Author:Taylor, John B.

Over the past few years I have been making the case for moving toward a more rules-based international monetary system (e.g., Taylor 2013, 2014, 2015, 2016a, 2016b, 2017). In fact, I made the case over 30 years ago in Taylor (1985), and the ideas go back over 30 years before that to Milton Friedman (1953). However, the case for such a system is now much stronger because the monetary system drifted away from a rules-based approach in the past dozen years and, as Paul Volcker (2014) reminds us, the absence of a rules-based monetary system "has not been a great success."

To bring recent experience to bear on the case, we must recognize that central banks have been using two separate monetary policy instruments in recent years: the policy interest rate and the size of the balance sheet, in which reserve balances play a key role. Any international monetary modeling framework used to assess or to make recommendations about international monetary policy must include both instruments in each country, the policy for changing the instruments, and the effect of these changes on exchange rates.

Using such a framework, I show that both policy instruments have deviated from rules-based policy in recent years. I then draw the policy implications for the international monetary system and suggest a way forward to implement the policy.

Regarding policy interest rates, there has clearly been an international contagion of deviations from monetary policy rules that have worked well in the past, as I argued in Taylor (2009, 2013). (1) This international contagion is due in part to a concern about exchange rates. If a foreign central bank with global financial influence cuts its interest rate by a large amount, then the currencies of other countries will tend to appreciate unless the odier central banks react and adjust their interest rates. Central bank reactions may also include exchange market interventions, capital flow restrictions, or some form of macroprudential actions aimed at international capital flows. These actions and reactions accentuate the deviation of monetary policy from traditional policy rules. To be sure, the international contagion of policy interest rates may be due to omitted factors that push interest rates around for many central banks. However, there is considerable econometric evidence that the deviations from policy rules are caused by unusual interest rate changes in other countries. There is also direct evidence from many central bankers who admit to these reactions. Norges Bank reports on monetary policy, for example, show that its policy interest rate is adjusted in relation to interest rate decisions at the European Central Bank (ECB), as described in Taylor (2013).

Regarding central bank balance sheet operations, there has also been international contagion, and this is also likely due to exchange rate concerns. Here an important distinction must be made between the central banks in large open economies and central banks in small open economies. In large open economies, the effects of balance sheet operations on exchange rates have been harder to detect than for central banks in small open economies. However, as I show in this article, there is now empirical evidence provided in Taylor (2017) of statistically significant impacts on exchange rates of the balance sheet operations by the Federal Reserve, the Bank of Japan (BOJ), and the ECB. There are also exchange rate effects in the small open economies where explicit foreign exchange purchases are often financed by an expansion of reserve balances.

A Framework and an International Policy Matrix

To investigate the international aspects of central bank interest rate and balance sheet policies, it is necessary to introduce a simple framework that captures key features of the recent economic policy environment. In the framework I use here, central banks have two separate policy instruments: die short-term interest rate and reserve balances. By paying interest (either positive or negative) on reserve balances, central banks can separately set the interest rate and reserve balances. This enables the central bank to intervene in other markets for a variety of reasons. In fact, in recent years, central banks in large open economies have purchased domestic securities denominated in their own currency through their quantitative easing (QE) programs. The stated aim has often been to raise the price and reduce the yield of these domestic securities, though there are sometimes references to exchange rates. In contrast, the central banks in smaller countries have purchased foreign securities denominated in foreign currency. The explicit aim of these foreign exchange purchases is to affect the exchange rate.

To operationalize this framework in Taylor (2017), I examined the balance sheets of three central banks in large open economies--the Fed, ECB, and BOJ--and a central bank in a relatively small open economy--the Swiss National Bank (SNB). Most of the purchases of assets by these banks are financed by increases in reserve balances. For the Fed, purchases of dollar-denominated bonds are financed by dollar reserve balances. For the Bank of Japan, purchases of yen-denominated securities are financed by yen-denominated reserve balances. For the ECB, purchases of euro-denominated securities are financed by euro-denominated reserve balances. For the SNB, purchases of euro- and dollar-denominated securities are financed by Swiss franc-denominated reserve balances. In addition, each of these central banks sets its short-term policy interest rate, which in the case of...

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