Monetary Policy and Uncertainties Yung Chul Park Korea University

I. Monetary Policy and Financial Stability Progression of the sub-prime crisis in the US suggests: - Monetary policy was largely responsible for fuelling a housing market boom by keeping the interest rate at a low level for an extended period. - It pricked the housing market bubble to trigger a major financial crisis. - The monetary authorities have shouldered much of the burden of resolving the crisis: it has printed more money and bailed out an investment bank.

One might ask: How could such a sophisticated institution as the Fed with access to the state-of-the art technology in economic analysis and forecasting and with a highly trained staff have blundered in provoking the housing market boom and then bursting it? - Central banks do not have enough policy instruments to sustain financial stability? - Price stability does not ensure financial stability? - Regulatory controls over financial markets and institutions need to complement monetary policy to preserve stability and safety of the financial system?

II. Monetary policy and Macroeconomic management > Japan has maintained a very expansionary stance of monetary policy, which has kept the central bank policy rate at near zero percent. The expansionary stance has not been effective in stimulating domestic demand. - Unlike in the US, it has not spurred the demand for real assets including housing, commercial real estate and land. - Instead, it has kept the Yen undervalued.

Monetary policy has therefore become an instrument of export promotion. - Exports have been the major source of growth in Japan. - Since the Yen is a free floating currency, Japan has been spared the accusation of currency. manipulation although it has been running a huge current account surplus. - China has been in a sense following the same policy but unlike Japan has become the target of global denunciation for its policy.

III. Monetary Policy and global Inflation Inflation has become a serious concern throughout emerging economies of East Asia. - One of the causes of the acceleration of the headline inflation is the rapid increases in the prices of oil, food, and other raw materials. - Another causes is claimed to be the expansionary stance of monetary policy in East Asia’s emerging economies, which is in turn the result of their reluctance to let their exchange rates appreciate.

Analysts seem to ignore the fact that the world economy is awash with liquidity, in particular US dollar liquidity as evidenced by the historically low interest rates throughout the global economy. - Much of the expansion of global dollar liquidity has resulted from the massive increase in the deficit on the US current account, which stood at more than 6 percent of GDP at the end of 2007. - There is not enough evidence suggesting that appreciation of the currencies of East Asia’s emerging economies including China will be effective in contracting the US trade deficit.

The increases in the dollar liquidity outside the US economy may have in part been responsible for the asset market bubbles in many developed as well as emerging economies, speculative demand for oil, food, and other raw materials. - The management of the sub-prime crisis has forced the Fed to supply large amounts of high powered money to make up for the drying up of liquidity in the U S financial markets. - Once the mechanism of credit creation is restored, the Fed’s crisis management will end up with excessive liquidity which will fuel further inflation.

IV. Inflation Targeting as a Framework for Monetary Policy In many emerging economies that adopt inflation targeting, monetary policy works through the markets for housing, other types of real estate, and foreign exchanges, in particular when money and capital markets are shallow and illiquid. - Free floating is very much limited in shielding small open economies from external shocks and often causes a high degree of volatility of the exchange rate. - The Markets for real estate tend to be heterogeneous, segmented, volatile and prone to the boom-bust cycle.

The preceding features of the real estate and foreign exchange markets add uncertainties to make the effects of monetary policy less predictable. - These attribute may constrain central banks in guiding households and firms in forming their expectation of future inflation. - Although the assets markets play an important role in transmitting the effects of monetary policy, central banks do not have at their disposal enough policy instruments to stabilize the prices of goods and services and those of financial and real assets at the same time.

It still remains debatable whether the headline or core inflation would serve as a better target for price stability. - When inflation is imported as it has been in recent periods as a result of the surge in the prices of oil and food stuffs, central banks will find it difficult to forecast future prices of these commodities. - They may lose credibility if they err in their predictions. - It is also unclear when and to what extent monetary policy should be tightened in response to imported inflation.

- The probability of losing credibility of inflation targeting increases when inflation is imported, simply because imported inflation is exogenous and beyond the contract of central banks. - When inflation is accompanied by economic slowdown so that the trade-off between inflation and growth cannot be exploited, inflation targeting may extract a price in terms of lost output and employment much more than otherwise. - A more flexible inflation targeting is the answer?