This is an audio transcript of the Economics Show with Soumaya Keynes podcast episode: ‘Have we reached the limits of monetary policy? With Hyun Song Shin’
Soumaya Keynes
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Central bankers in the rich world are in a pretty OK place right now. Or at least they’re in a much better place than they were in a couple of years ago. They have mostly fought off inflation without breaking the economy, and it looks like they’re out of the funk that they were in the 2010s, when interest rates were on the floor and they were having to resort to other ways of getting inflation back to their target. Now, this week, I’m joined by Hyun Song Shin, economic adviser and head of research at the Bank for International Settlements, which is a sort of bank for central banks. I’m going to ask him about how much credit central bankers should get for this recent fall in inflation. And also, if we were to go back to that low rates world, what are the problems associated with the other tools that central banks have? I’m going to ask him, what are the limits of monetary policy.
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This is the Economics Show. I’m Soumaya Keynes in London, joined by Hyun speaking from Basel. Hyun, hello!
Hyun Song Shin
Hello, Soumaya. Thanks for inviting me.
Soumaya Keynes
Thanks for joining. OK, so you have just put out the BIS’s annual economic report, where you sort of do this impossible task of reflecting on what we’ve learned from the last 25 years of monetary policy. So somehow on this show, I’ve been making a thing about demanding that people give completely arbitrary scores for very, very complicated questions. So the first thing I’m going to ask you to do is to ask you to give central banks a mark out of 10 for their performance. I want no explanation. I just want the number. OK. And so first of all, I want a mark out of 10 for the performance over the past 25 years.
Hyun Song Shin
I’d say, eight out of 10.
Soumaya Keynes
OK. OK. Pretty positive. OK. And now for their performance over the past three years.
Hyun Song Shin
I’d say nine.
Soumaya Keynes
Nine. OK. More positive. Not a huge range there. But we can work with that. Well, let’s start by talking about the most recent episode. You gave it a score of nine. A very good score, but why not a 10?
Hyun Song Shin
I think it would have been 10 out of 10 had central banks basically anticipated the shock and reacted in such a way as to, you know, head off the inflation that happened. But, they were not able to do that, partly because these were very unusual shocks. In particular, the relative prices were really thrown out of kilter. And, you know, to be concrete, the relative price of goods just rocketed up relative to services, you know. You remember all the discussions about supply chain snarl ups and used car prices and so on.
And to a large extent, those shocks have not fully dissipated. And we feel that this is actually one of the cautionary points we need to draw from the recent experience that the job is not yet done. In fact, if there is a risk of a flare up in inflation, you know, in the last mile, it would be these relative prices, by returning to the historical trend actually gives another twist to inflation.
And, you know, we should not be complacent about this because, you know, we’re not, done in terms of conquering inflation. Yes, inflation has eased a lot since the peak in ‘22, but in many jurisdictions it is still running above target. And, worryingly, in several jurisdictions recently we see upward surprises. So inflation is coming in not only above target but actually higher than, you know, expected. You know, it’s not universal. But, you know, we’ve had recent cases in Australia, Canada, even in the euro area. We’ve had these sort of, you know, little bit of unwelcome surprises, which actually, I think does underline the fact that the job is not yet done.
Soumaya Keynes
Can you talk a bit now about what you think would have happened if they hadn’t acted, if they hadn’t acted to raise rates? So in your report, you talk about a move to a high inflation regime.
Hyun Song Shin
Exactly. That’s right. So the point there is inflation is an average across many, many sectors. And one of the things that’s really quite intriguing about inflation is that there is a common component as well as an idiosyncratic component for each sector. So you know, when inflation is well behaved, what you tend to see is that the common component doesn’t play that bigger role. In other words, you know, the price shocks that hit various sectors, all higgledy-piggledy, they go in different directions. So some rise, some fall. The common component doesn’t play that big a role.
In a high inflation regime, what happens is that common component plays a much more important role. So it’s like saying when inflation is high, it’s as if money itself is falling in value. And that’s being reflected in the generalised increase in prices. So the key relationship that we have highlighted over the last few years is that when inflation is high, the common component plays a much more important role.
You know, I think there are very good economic reasons for that. When inflation is high, people notice it. It becomes very salient. And people’s behaviour is guided by what’s happening in the economy. And so pricing, wage negotiations, all of the economic activity are then suddenly revolving around what the latest inflation print is. And so when you allow the economy to transition into a high inflation regime, it actually bakes in the self-sustaining, you know, impulse in inflation. And so the role of monetary policy is to prevent the economy from sliding into that regime.
Soumaya Keynes
So is there a sense in which this high inflation regime that you’re talking about is one in which monetary policy is less effective or it’s harder to control inflation? And so the purpose of monetary policy is to make sure that we stay in that low inflation regime where all the tools are going to work really well.
Hyun Song Shin
Well, actually, Soumaya, it’s actually a little bit of the opposite. So, paradoxically, it’s the high inflation regime where monetary policy is more effective in the following sense.
So if you look at the impact of higher interest rates, that tends to be higher on the common component of inflation. So when inflation is running high and you raise interest rates, it actually does a very good job of arresting that common component. It’s that sort of erosion in the value of money that is being addressed when you raise, when you raise interest rates.
When inflation is well-behaved and you’re in the low inflation regime, all the price changes are sort of idiosyncratic. You know, it’s higgledy-piggledy. Some go up, some go down. And there the impact of monetary policy turns out to be, if anything, less effective.
Soumaya Keynes
What’s the mechanism that you think is most important there? Is it inflation expectations. Is it kind of mechanical effects on, you know, higher rates, people have less cash, there’s less demand, people spend less, that kind of thing?
Hyun Song Shin
I think it’s definitely the demand channel, as being one important channel. And, you know, we can think about the Phillips curve-type of mechanism there. When there is slack in the economy, you know, there’s less demand. And that tends to put downward pressure on prices.
But your comment about inflation expectations is also very key because once inflation expectations have been unmoored, and what you see is that, you know, this common component being baked in, both in what’s happening now as well as, what people are expecting a few years hence, then it’s going to be much more difficult to bring that down. You will need a much bigger dose of monetary policy medicine to bring it down, relative to when inflation expectations are much more stable.
Soumaya Keynes
Can I ask now about a bit more about this counterfactual case? Right. So I want to prod you a bit on this excellent score that you gave as nine out of 10 for central bankers recent performance. And, you know, the narrative is that they reacted forcefully. They were clear they were going to get inflation back down. It was mostly effective. Maybe we’re not all the way there yet, but actually they did a reasonable job. Inflation is pretty much back near target. The economy hasn’t crashed, you know, well done then.
So there’s one narrative that they did well. There’s another narrative that they just got really lucky. There was maybe a one-off shock to demand that dissipated from fiscal stimulus. There were the supply chain shocks that unwind of their own accord. Inflation expectations, you know, to the extent that they were elevated at any point, actually, workers were never going to have much power to translate those into higher wages. So one of the kind of fear about a wage-price spiral was unfounded. And so really, maybe now they’re just taking credit where it isn’t due. What’s your response to that?
Hyun Song Shin
I think that’s a very interesting debate, Soumaya. And, there is undoubtedly a big role for the unwinding of shocks. So, you know, there was first the Covid shock and the supply chain snarl-ups, used cars prices and so on. We also had the huge energy shock, which hit Europe especially hard. And as those shocks unwound and as they see through and the headline inflation also dissipated, there’s a very reasonable case that those prices would have, you know, moderated as well.
So the crucial question is a counterfactual one, which is: Yes, granted all of that, but would we have had the same success in inflation had central banks not raise rates? I think at the very least, raising rates would not have done any harm to bringing inflation down. I think that’s a very, very mild statement. I think everyone would agree with that. I think you could argue through various modelling techniques, you know, you can look at a theoretical model to see what would have happened to the trajectory. And we put out a bulletin, BIS bulletin at the end of last year on exactly this exercise. I think inflation would have been definitely higher in those theoretical exercises.
You can also do, you know, empirical exercises like, can we draw some evidence from the sectoral differences in the way that prices have behaved? So one of the exercises we did, and I saw that Chris Giles picked up on this, on his, you know, in his column, one of the things that we did was to look at the cyclically sensitive sectors. And, you know, we provide this evidence that in the cyclically sensitive sectors saw the largest decline in prices. And I saw that Chris, said in his blog that, well, you know, you’re mixing up the transport sector and other sort of energy-related sectors, which, of course, you know, has a lot of the headline element.
You know, we should have published also our robustness checks on that. We can take out those kind of, energy-related sectors like transport. It’s a remarkably robust finding. But I think, you know, I think these as interesting as these scientific debates are, Soumaya, I think, from a practical perspective, the job is not done. And it seems a little bit strange that we’re having this kind of debate when the job is not done and we’re still getting these unwelcome surprises, you know, flaring up. So it’s not as if we’ve won the battle and we have the luxury of looking back and have these, you know, esoteric debates.
Soumaya Keynes
OK. Well, look, let’s take a luxury that you say we don’t have and look back even further at even more esoteric debates. But that might not become, you know, that esoteric because it is possible that within the next few years we might find ourselves back in the world that we were in the 2010s with very low rates tearing our hair out about, you know, the effectiveness of monetary policy. And so this is one of the themes in your report where you talk about the problems of, kind of, prolonged easing of very low rates that are in place for a very long time. Could you talk about those?
Hyun Song Shin
Well, in a way the story is familiar, right? So what are we doing when we have negative rates, very large central bank balance sheets? Well, you know, we’re trying to encourage borrowing so that we can bring, you know, spending forward. You are encouraging households, firms and indeed governments actually to borrow more. So that’s certainly one sort of intention, we encourage spending.
The other would be that we, you know, want to ease financial conditions sufficiently that there’s more risk-taking in the economy. So, we want financial institutions to take risks, to lend more, market participants to lever up more, have more aggressive strategies vis-à-vis assets, and so on.
Of course, you know, that would have some impact on the real economy, but it’s also storing up, you know, other longer term issues. So debt, for example, you know, it’s a way of just reallocating spending. I mean, hopefully the debt finance spending will also have an impact on growth. So then that will finance itself. But to the extent that it has only a limited effect on growth, you are simply reallocating spending. And you have to repay at some point.
So another effect, of let’s say central bank asset purchases would be that you’re buying long-term bonds. Well, you know, bonds of various maturities. And you’re going to raise the bond price by doing that and lower the interest rate and you lower the yield on those bonds. And so what that means actually then, it’s become quite advantageous to borrow long. So rather than having a floating rate mortgage, there’s been this turning out of borrowing where borrowers have increasingly locked in longer term borrowing by fixing their debt contracts for longer. And this is true even of governments.
Now, longer term borrowing is, of course, very good. The problem is that if you need to refinance because, you know, you’re not to having to refinance, a big slug at the same time, you know, you’re not facing that rollover problem. On the other hand, longer term bonds are much more sensitive to rising interest rates. And the US bank, SVB, Silicon Valley Bank, found that to its cost when its long term government bond holdings really depreciated in value as rates rose. And, you know, ultimately that was a contributing factor to its demise. And so it’s a little bit double-edged. This very long period of low for long from the 2010s has really increased that potential for interest-rate risk. So that’s been one of the, if you like unintended I think consequences.
Soumaya Keynes
OK. Can I ask you now about some of the other tools that were deployed in that time? So there was a lot of emphasis put on central bank communication. So forward guidance. You know, central banks couldn’t change rates much at the time, but they could promise that they would keep them low for a long period of time, and that was supposed to affect the expectations and the real economy. How confident are you that that sort of thing really worked?
Hyun Song Shin
I think, you know, if you look at the theories and the theoretical models, I mean, they work perfectly in those settings.
Soumaya Keynes
Why do I get the sense that a lot of things work in theory, but not very well in practice?
Hyun Song Shin
Well, I mean, sometimes we know something works in practice. We just have to find out how it works in theory. That’s the luxury. But in this case, it turned out that, it doesn’t really, you know, operate as exactly as you had hoped because this is not a commitment. And therefore, you know, you always need to have an exit strategy. So when you go in for forward guidance, you have to leave sufficient room for you to unwind. And as it were, sort of even though you had guided the market, that certain policies would remain in place, you know, until, these circumstances held, you may want to actually reverse and get out of it, actually. And this is actually what we saw during Covid. That was a very, very, you know, unusual and really quite a large shock that hit the global economy.
So whatever your plans were in providing forward guidance, as the circumstances change and as inflation started flaring up, you would need to recalibrate. Now, the issue is that communication is one of these things where although you can put all of the provisos in the small print, no one actually reads a small print. All they look at is the headline. Now, it’s not simply a psychological block. Actually, this is actually a very important feature of financial markets. In financial markets, it’s not just one rational individual that you’re dealing with. The market is not a person. We should not anthropomorphise the market. Market is just a collection of entities. And although market prices have some attributes of beliefs, they’re not actually beliefs. They’re just outcomes of whatever interaction is happening in the market.
So it’s a mistake to think that you’re actually talking to a single rational individual that you can reason with. The market is the outcome of a very complex interaction. And in that mix, what tends to happen is the outcome latches on to the headline. It’s not the provisos that the market takes account of. It is basically the headline. And so when you know, you explain very fully and then you reverse course, the market doesn’t say, oh, yes, you’re completely right. And it’s completely reasonable. It just has a fit. It’s not that the market is not rational. It’s, you know, that’s just the category mistake. It’s just a mistake to attribute irrationality to the market. The market is not a person.
Soumaya Keynes
OK. So central bankers would love to say, look, we’re going to keep rates low unless the data suggests that we should do otherwise or unless these shocks come along and the market in its collective form just ignores everything after we’re going to keep rates low. And then when the data or the shock comes along and, and the central bankers change course, the market just freaks out.
But this is so interesting because, you know, it’s one of the biggest frustrations that I often hear from investors and market participants who are saying, you know, please just treat us like adults. And so I suppose what you’re saying is, yes, one-to-one, you are adults, but collectively you’re insane and we can’t trust you with that extra information, essentially.
Hyun Song Shin
And so when we look at forward guidance or when we look at communication more generally, it’s very important for us to bear in mind the limits of what kinds of messages the market can absorb and will actually price in. And to that extent, simple messages tend to be much more effective for the market commentators who say, look, treat us as adults. Please give us full transparency. Normally what they mean is please tell us what you’re going to do at the next central bank meeting. Of course, you know, we can’t do that, but it’s one of the attributes that the more you say, the more complex that interaction is going to get.
Soumaya Keynes
Well, look, why don’t we cut to a break now. And when we get back, I’m going to ask you for some more prescriptions, some more lessons for central bankers. What should they be doing about all of these limits?
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Soumaya Keynes
We are back from the break. OK, so, I think we’ve already got a flavour of some of the things that central bankers should do, you know, have simple messages. Be wary of keeping rates too low for too long. Don’t get complacent, the job is not yet done. What are some other prescription, some lessons that we’ve learned from the past 25 years?
Hyun Song Shin
Yeah. So one of the other lessons that we haven’t spoken about, the so-called complementary tool, and this is something that emerging market central banks are, really, you know, come to appreciate in the same way that the value of money is really the focus of monetary policy. You know, one interpretation of the value of money is your exchange rate. It’s the value of your money relative to some, if you like, you know, reserve currency and, emerging markets that have been through financial crises instinctively look to the exchange rate when they look at financial instability.
So when inflation is running high and that common component of inflation is really driving everything, you also see your currency also dropping in value. So what are some of the implications of that? Actually you know we talked earlier about, you know, are we going back to the low interest regime. Will we have high interest rates here to stay? You know, one reason for thinking that we’re not going back to those low interest rate days and in fact, some of this high interest rate regime might actually stick is what we see out there in terms of potential, you know, global trends that are coming up.
So, you know, one thing that we do see is that there is greater political appetite for greater use of fiscal policy. And we see it across the world. Sometimes it’s accompanied by political instability as well, or political uncertainty. And these are themes that are very familiar to emerging markets. But it’s something that is becoming, you know, much more of a sort of global theme.
And in that kind of setting with, more expansive fiscal policy, and, you know, protectionism and, you know, these, tectonic plates that might be shifting globally.
You know, we may be entering a new regime where interest rates will be higher. You know, structurally, that’s because fiscal policy is more expansive. And then this means that monetary policy needs to adapt to that. Sometimes, you know, they could be operating at cross-purposes. Of course, you know, that shouldn’t be the case. But, you know, if the policy authorities are not co-ordinated, you know, that’s also a risk. In all those settings, there has to be, I think, a recognition that other policy tools will need to play that part as well.
So as well as monetary policy, you know, monetary policy doesn’t operate in a vacuum. There is fiscal policy in particular and also prudential and you know, both micro-prudential and macro-prudential policy also needs to play their part. So. So that’s the other set of issues that we discuss in the chapter, the role of complementary policies.
Soumaya Keynes
OK. Hang on. But there are a couple of things to take away from that. One is OK, look we’ve got this more expansive fiscal policy, more protectionism. And therefore central bankers should be ready for rates to be higher permanently. And, you know, we’re maybe not going back to the world in the 2010s.
And the second is the fiscal policymakers should maybe be more careful. You know, they should recognise that if there are higher rates, and that’s partly a consequence of their more expansive fiscal policy. And perhaps they should think twice about, you know, borrowing as much as they are. Is that essentially the correct interpretation?
Hyun Song Shin
Yes, that’s exactly right. So, you know, we quite often think about the relationship between monetary policy and fiscal policy in one direction where we say, well, if fiscal policy is doing this, what should monetary policy do? So how is monetary policy affected by the fiscal policy stance? So that’s the first part of your question.
But there is a reverse causation, which I think is going to be much more important going forward, which is what has been or what is the impact of the monetary policy stance on the fiscal stance itself? So how has spending and taxation been affected by the period of very low for long? I think there is a sense that during the 2010s, during this period of very low for long, fiscal policy had fewer of those constraints which actually reined in spending, and, you know, cautioned against tax cuts and so on. We saw quite a big boost to the fiscal stance itself. And we’re seeing it especially post-Covid.
Soumaya Keynes
OK. I just have one last question, which is going to seem like a bit of a curve ball, but I know it’s on something you’ve been working on. So I want to ask about AI, right, and how AI is going to affect the discussion that we’ve been having about the potency of monetary policy. You know, whether we’re going to be in a low or high-rate regime, how AI is going to matter for the practice of central banking. Can you give me your kind of 30,000-foot answer?
Hyun Song Shin
It will have to be really 30,000-foot, Soumaya. You know, we could have a whole podcast discussion on that subject, but I’ll keep it short. We’re focusing on the impact of AI for central banks, and there are two aspects we need to bear in mind. One is that AI will affect the economy. We don’t know exactly how, but it will affect the economy. And therefore the central bank is a very interested observer in how it will affect the economy, because it will definitely impact the work of central banks, as you know, stewards of the economy.
Soumaya Keynes
Is it unambiguous which way it would go in terms of the effect on inflation? Could you tell a story that it would make inflation higher or lower?
Hyun Song Shin
Unfortunately, I have to disappoint you there. It’s actually ambiguous and the reason is this. So there’s one channel which works through the labour market. So some jobs will be displaced. It will make other jobs more productive. Because, you know, these AI tools can be complements to the skills that workers already have. And it could change the structure of the labour market that way.
But there’s another channel which is about the innovation process itself. So even if AI raises productivity as a one-off, so we have a one-off increase in productivity, that’s just a one off shift. That’s not going to be, you know, such an important, long run effect.
But the much more interesting question, much more important question is what will AI do to the innovation process itself? How would it affect the growth rate of productivity? Now, there are many respectable people who know a lot more about the science of AI than me, who argue that, in fact, what AI will do is to open a much faster rate of innovation, open up a much faster rate of innovation through various tools that make science much more productive towards a real economy. It turns out that many of these applications are actually very amenable to central bank users. In fact, the central banks can be at the cutting edge of some of these tools.
Soumaya Keynes
Because they have lots of fancy data that AI models love.
Hyun Song Shin
Lots of fancy data which can be combined as a public authority. You are really working very closely with the statistical agencies. There’s a lot of real-time data, and it’s actually very promising. We can just leave it there.
Soumaya Keynes
OK. Well, I mean, this sounds like an area where maybe central bankers could be cool.
Hyun Song Shin
Well, I think we, I thought we were already cool. But, you know, we could be even cooler.
Soumaya Keynes
OK. Well, on that totally realistic note, why don’t we wrap up there? Hyun, this has been so interesting. Thank you so much for joining me.
Hyun Song Shin
Thank you, Soumaya. It was a pleasure.
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Soumaya Keynes
That is all for this week. You’ve been listening to The Economics Show with Soumaya Keynes. This episode was produced by Edith Rousselot with original music from Breen Turner. It is edited by Bryant Urstadt. Our executive producer is Manuela Saragosa. Cheryl Brumley is the FT’s global head of audio. I’m Soumaya Keynes. Thanks for listening.
