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ByAntonio Carlos Lemgruber

For example, the open economy inflation targeting models of the last 15 years – designed to generate rules for monetary policy – are being accused of neglecting entirely the question of “asset inflation”, as opposed to the inflation of goods and services. In the last 15 years, there was a major discrepancy between asset inflation and goods inflation in many countries – leading to monetary policy mistakes – and unfortunately it might happen again in the next few years.

Another example is the system of floating exchange rates, introduced around 1973 to replace Bretton Woods and the dollar standard. First of all, it was never a pure and clean floating system due to strong Government interventions in many countries at many different moments of time. More important, however, the growing importance of China and other Asian countries in international trade and international finance brought new challenges to the system, to the extent that the Asian exchange rates – particularly China – are fixed and pegged to the dollar or to a small basket of currencies. Some analysts call the existing exchange rate system as Bretton Woods 2.

An additional point to be raised and questioned is exactly the surprise of the duration and the size of the present Great Recession. In spite of some significant recession periods in years such as 1974 and 1982 (clearly related to oil shocks and policy responses to the shocks, such as interest rates above 15% per year in the USA), the fact is that in the whole postwar period until 2007 there were only small real GDP variations, causing some economists to say that business fluctuations were clearly avoidable and controllable through economic policy.

These are important macroeconomic challenges – among others. How to deal with financial bubbles or asset inflation? Should we move to Bretton Woods 3, taking into account the increasing globalization of financial markets, which leaves only a small margin for monetary policy independence even with floating exchange rates? And finally – after 2010 – can we repeat and confirm Bernanke’s promise to Milton Friedman that there will never be a Great Depression any more, and that “output gaps” will go back to a certain level of normality, as far as business fluctuations are concerned?

Naturally, this is not the place to point out all solutions for these macroeconomic challenges. However, it should be useful to try to make some guesses based on some new beliefs which have been generated by the present Great Recession.

First, asset inflation. There is no doubt that monetary policy rules for interest rates must take into account from now on bubbles and asset prices – not only inflation and unemployment. Taylor’s rule – introduced in the early nineties – must be enhanced to account for asset inflation. Or else, we will see again new bubbles very soon. In order to avoid it, interest rates will probably have to be raised before the end of 2009 in the USA and eventually abroad even if by small percentage points.

Second, exchange rates. In the seventies, flexible exchange rates were introduced to allow independence of monetary policy for many countries. With globalization of finance in the last 30 years, this does not happen anymore. Monetary policy (interest rate policy) lost independence, irrespective of the exchange rate regime. Financial markets ignore devaluation expectations and move funds based on interest rate differentials. Markets act as if – either under fixed or floating rates – devaluation expectations were zero, Given all these new dilemmas, we believe that we will go back to systems where exchange rates will be somewhat pegged along the lines of optimum currency areas, as well as under some monitoring of the IMF (remembering Bretton Woods), due to specific and important cases such as China.

Third, GDP variability. This is probably the major challenge. Undoubtedly, the 2007/2010 recession has been a big surprise, as far as duration and depth is concerned. Here again, we believe that economists will have to consider that there was a sort of “benign neglect”, produced in the last 25 years when the world economy had a golden age period as far as economic growth is concerned. As a consequence of that, as we mentioned before, macroeconomists began to focus on inflation, firmly believing that private free markets would adjust well and naturally, and generate a 2 or 3% output growth per year (the so-called potential output), with only small deviations from the trend, that is, minor business fluctuations. Unfortunately, this neglect reached a point after 2002, when interest rates became entirely out of tune with asset inflation and economic growth.

In the meantime, economists should pay a lot of attention to: real effective exchange rates, output gap measurement, and some early news about the possibility of new asset bubbles in 2010 and on. We are expecting positive economic growth in 2010 in many countries, including the USA. Almost a V recovery. Paul Samuelson used to say: “If you have to forecast, forecast often.” In May 2009, our forecasts and challenges are entirely different from October 2008 (eight months ago).