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The IMF’s next test

By Gita Gopinath

Is it prepared to provide “forward guidance” on how it will tackle potential disruptions in financial markets?

This October, central bankers, policymakers, private-sector executives, academics, and representatives of civil-society organisations will convene in Washington, DC, for the annual joint meeting of the International Monetary Fund and the World Bank. Among the most important outcomes this year will be the IMF Board of Governors’ decision regarding how to address current international monetary issues.

Global economic conditions remain precarious, with no signs of healthy GDP growth in the eurozone, a weak recovery in the United States, commodity-exporting countries like Australia suffering from diminishing Chinese demand, and an emerging-market slowdown that is now well into its third year. In such an uncertain environment, even small changes in advanced countries’ monetary policy can destabilise developing economies.

For example, the mere announcement in May that the Federal Reserve would “taper” its purchases of long-term assets drove down the value of emerging-market currencies. With the Fed considering exiting its quantitative-easing policy altogether and raising interest rates over the next year, global markets are set to experience significant turbulence.

The world needs strategies to mitigate this looming volatility. The IMF – whose mandate is to maintain balance-of-payments stability worldwide – should be the institution that provides them. Rather than waiting for a crisis to erupt before intervening, the IMF should provide “forward guidance” on how it will tackle potential disruptions in international financial markets.

Central banks are increasingly using such guidance to communicate monetary policy and anchor market expectations. For example, the Fed has pledged to keep interest rates low at least until the unemployment rate falls to 6.5% – a move that has arguably lowered long-term borrowing costs.

Likewise, Mark Carney, in his first policy action as Governor of the Bank of England, announced forward guidance for short-term interest rates. Although the effect of such interest-rate guidance on the economy cannot be determined without additional data, there are many arguments in its favour.

Perhaps the most telling recent example of a central bank using forward guidance effectively was European Central Bank President Mario Draghi’s July 2012 announcement that the ECB would do “whatever it takes” to ensure the euro’s survival.

That pledge alone stabilised borrowing costs and dramatically reduced interest-rate spreads for struggling eurozone countries. Investors’ belief that the ECB would buy up government debt if bond yields rose too high was enough to restore calm; indeed, no central-bank intervention in secondary markets has been necessary since then.

The IMF’s policy tool here is the dollar amount that it is willing to pledge as a backstop in balance-of-payments crises. By promising to intervene in vulnerable markets in the event of excessive financial volatility, the IMF, as the largest player, would reduce coordination problems among investors.

Moreover, by communicating ex ante its willingness to provide emergency funds, the IMF would reduce the stigma against countries that turn to it for assistance – a stigma that has led countries to delay requesting support until it is too late to mitigate domestic political damage.

The good news is that the IMF has already shown some interest in the idea of forward guidance. At the annual meeting of central bankers in Jackson Hole, Wyoming, in August, IMF Managing Director Christine Lagarde suggested that the Fund would intervene to help emerging markets in crisis.

The bad news is that Lagarde’s vague announcement seems to have done little to shape market expectations or make governments more comfortable requesting IMF assistance. This underscores a fundamental point: successful forward guidance requires, above all, credibility.  Today, G-20 leaders must again use their influence over IMF policy, this time to push for timely forward guidance and another round of reform of the international financial architecture.

This is also an opportunity for the IMF to formulate and announce its policy to address global financial market turbulence.

To be sure, there is no shortage of issues – such as poverty eradication, aid effectiveness, and international development – to be discussed at the upcoming IMF/World Bank meeting. But the failure of IMF leaders to produce a forward-looking strategy to confront impending market turmoil would undermine progress in all of these areas. The last thing that a still-fragile global economy needs is more uncertainty.

Gita Gopinath, Professor of Economics at Harvard University, is a visiting scholar at the Federal Reserve Bank of Boston and a research associate with the National Bureau of Economic Research (NBER).

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