Speech

After the Crisis: The Outlook and the Long View

November 8, 2017

Thank you, Maury. Good morning. I would like to express my appreciation to the Bank of England and Hong Kong Monetary Authority for joining us to sponsor this important conference. Welcome to the IMF.

This is the third time we are holding this conference, and the first here at the IMF. Our approach is to bring together academics and senior policymakers from around the world for discussions on issues related to prudential and monetary policies.

I would like to offer some broad perspectives on the issues you will be examining in depth in your discussions over the next two days:

• The current macroeconomic outlook nearly a decade after the Global Financial Crisis;
• Structural issues that we see emerging in the advanced economies that may point to low interest rates over the long term; and
• The policy challenges and transitions that governments and financial institutions may face as a result.

Let’s begin with the big picture.

A Strengthening Recovery

After a profound disruption of the global economy from the global financial crisis, the good news is that we finally are experiencing a firm and strengthening recovery led by the advanced economies.

Our latest World Economic Outlook forecasts 3.6 percent growth this year and 3.7 percent in 2018. The advanced economies are all growing, as are most emerging markets.

We see both consumption and investment experiencing an upswing. This, especially given import intensive investment, has contributed to an acceleration of trade, which for the first time in several years is growing faster than GDP.

That said, we need to do better. In many countries, inflation remains weak, a reflection of slow wage growth and remaining slack in some advanced economies.

Just as significantly, about 25 percent of the world, in per capita GDP terms, is not growing. Most of these countries are grouped in the commodities exporters of the developing world, particularly the oil producers.

At the IMF Annual Meetings last month, the Managing Director called for the Fund’s membership to use this moment to “fix the roof while the sun is shining.” In other words, to put in place the reforms that can provide additional growth momentum.

The policies we are discussing today are part of that effort, and can continue to play a crucial role in strengthening the foundations of recovery.

The accommodative monetary policies that the central banks put in place after the crisis have been instrumental in restoring growth.

The IMF has firmly and consistently supported accommodative monetary policies as a pillar of the policy framework for recovery. With core inflation still below the targets of several advanced economy central banks, the continuation of these policies remains necessary.

We also support the pace at which the Federal Reserve and other central banks are proceeding with normalization.

We certainly hear the voices of concern in the financial markets about emerging risks attributed to the low interest rate policies. In fact, the Fund has highlighted these risks in its own work, including the most recent WEO and Global Financial Stability Report.

The pursuit of higher yields has driven up assets prices across many markets. Investors have become increasingly exposed to credit, maturity and liquidity risks. Meanwhile, volatility remains subdued, suggesting that many investors may have become complacent. Corporate and sovereign debt is rising in many countries.

But it was understood that we likely would head in the direction of heightened risk appetite when the central banks embarked on their extraordinary response to the crisis. Encouraging businesses and households to take on more risk is precisely one intended effect of an accommodative monetary policy. And that is one reason we and many others have sought a deepening and refinement of macroprudential supervision and regulation—a point I will return to in a moment.

The Long View on Interest Rates

That’s the immediate outlook. This conference is also taking the long view. We also need to consider the implications of a long-term decline in real interest rates over the past three decades in the advanced economies. This highlights slow-moving, structural factors at play across many countries. The experience of Japan, with its persistently low rates and a flattening yield curve, may be instructive as we look ahead.

This past April’s edition of the Fund’s GFSR explored these developments in detail. For those of you who might not have that chapter at your fingertips, allow me to lay out some of the findings. They are germane to today’s discussion.

We addressed the likely impact of two key structural changes occurring in the advanced economies. The first is the demographic changes most evident in many advanced economies, and, soon, important emerging economies like China. The includes the greater longevity of their populations, and the rapid aging of their societies as birth rates drop.

This rising longevity is propelling an increase in savings in many advanced economies as households prepare for longer retirement. We see this most notably in Japan and euro area countries.

The second structural factor at play is declining productivity growth, which we have witnessed in many economies since the global crisis. This reflects many trends, including the waning boom spurred by the revolution in information and communications technology; slowing global trade; and weaker capital accumulation. In some countries, population aging is also weighing on productivity growth. Lower total factor productivity will dampen the demand for credit and financial intermediation.

I should add a caveat on productivity. We have been taken by surprise before by the impact of technological change—for both better and worse. It happened with IT, and it could happen again. We face many unknowns.

From this perspective, in the financial sector we may witness substantial changes due to digital innovations. Fintech presents financial institutions with many challenges and opportunities. It could disrupt, and it could open doors. So, a lot of what I am about to say about financial services may not take into account changes that we are about to experience.

With that in mind, let’s stay with the possible impact of the structural changes I have been describing. Demographic change and declining productivity growth could produce a decline in the level of steady-state economic growth, itself potentially adding to the pressures toward lower nominal and real interest rates.

A Challenge to Business Models

Taken together, these factors could have significant implications for the normalization of monetary policy.

An environment of prolonged low rates also could present a considerable challenge to financial institutions, bringing significant changes to business models, especially at banks, insurance companies, and asset management firms.

Our analytical work suggests that along with lower short-term rates, the yield curve would be flatter than if the growth rate were higher. This would strengthen the implications of low rates for the profits—and even survivability—of financial institutions.

In this setting, tail-risk exposure is likely to increase as banks reach for higher yields.

At the same time, businesses would be adjusting to shifting demand. Aging populations would have less need for credit and more for insurance products related to health and long-term care.

This does not bode well for smaller banks, which could face falling demand for business lending and have a hard time competing for the services that an aging population will demand.

The result is likely to be continued consolidation in the banking industry that would hit small banks especially hard. Over the past two decades, we have seen this take place in Japan—a direct result of demographic change and prolonged low interest rates.

The insurance industry also will face a bottom-line challenge. It may experience a drain on its capital because of the need to fund liabilities taken on during past periods of higher interest rates. Many of the industry’s business lines will struggle to turn a profit in a slower-growth, lower-rate environment.

In the area of pensions, defined-benefit pension plans provided by employers are likely to become less attractive than defined-contribution plans, which offer more portability.

Low rates also could affect asset managers, because investors will be less inclined to pay high management fees. So, the demand for passive index funds will likely continue to grow.

The Policy Implications

What does this mean for government policies?

For the banking sector, the challenge will be to provide and sustain a legal and regulatory framework that limits excessive risk taking amid lower returns. Supervision and regulation of the asset management industry will become more important as its share of financial services expands.

These challenges point to the role of macroprudential policies. They call for clear assessment of systemic risks.

This is where it is useful to circle back to the current economic environment.

As the global recovery gathers strength, the goal should be to increase resilience as potential vulnerabilities emerge. But we face a fine policy balance: distinguishing between the policy response to a normal recovery and responding to danger signs.

That also poses challenges both for the calibration of specific tools, and for choosing between standard macroprudential measures and newer, less traditional ones

With this in mind, we have recently offered recommendations about ways in which macroprudential might be strengthened in light of specific, potential risks to stability.

For example, borrower-based measures could be introduced or tightened to slow fast-growing overvalued segments, and bank stress tests must assume more stressed-asset valuations. Capital requirements should be increased for banks that are more exposed to vulnerable borrowers.

Where rising household debt is a concern, consideration could be given to measures such as limits on debt-service-to-income and loan-to-value ratios. For nonfinancial corporate leverage, sectoral capital requirements and risk weights on foreign currency credits can play an important role.

At the same time, there needs to be increased focus on the regulation of nonbank institutions. This is intended to limit risk migration and excessive capital market financing. Greater transparency is essential.

The need for financial sector stability extends beyond the advanced economies. The emerging markets have benefited tremendously from capital flows generated by a decade of low interest rates. However, many have experienced a build-up of leverage and associated vulnerabilities.

Take, for example, the increase of Chinese debt since 2007. We have seen China take concrete steps to improve risk management and address the buildup of maturity and liquidity risks under shadow banking. These are crucial examples of heightened regulation and supervision. These measures must remain a priority and need to be accompanied by slower credit growth.

There is a basic message to accompany our approach to macroprudential policy: by strengthening our defenses now, we will only be better prepared in the future. That is germane to the longer-term changes we may witness as a result of the structural changes that could affect the interest rate environment.

I look forward to hearing your thoughts on these topics over the course of the next two days. Thank you very much.