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Thursday, March 09, 2006

Geithner: Monetary Policy in the Global Financial Environment

As noted in this Bloomberg report, NY Fed president Tim Geithner gives considerable weight to fixed exchange rate regimes as the cause of the current pattern of global imbalances. As these countries pursue fixed-exchange rate regimes, it puts upward pressure on aggregate demand and inflation in the U.S., and the Fed may be forced to implement policy to offset the potential inflationary consequences:

Geithner Says Global Capital Flows May Require Fed to Raise Rates More, Bloomberg: Foreign purchases of U.S. bonds are keeping long-term interest rates low and may require the Federal Reserve to counter the effects with higher short-term interest rates, New York Fed President Timothy Geithner said.

''To the extent that these forces act to put downward pressure on interest rates and upward pressure on other asset prices, they would contribute to more expansionary financial conditions,'' Geithner said... U.S. interest-rate policy ''would have to act to offset these effects in order to achieve the same impact on the future path of demand and inflation.''...

Geithner discussed Fed Chairman Ben S. Bernanke's view that the U.S. is absorbing a global "savings glut" and suggested instead that money is flowing to the U.S. because Asian economies are buying bonds to sustain inflexible currencies. ... "Sustaining that objective in the past several years has required large accumulation of dollar assets. The scale of this activity has been particularly dramatic in parts of Asia."... Oil exporting nations are also accumulating large amounts of dollar reserves, Geithner said...

Geithner didn't speak directly about the near-term path of monetary policy or the state of the U.S. economy. ...

Here's the speech:

U.S. Monetary Policy in the Global Financial Environment, by New York Fed President Timothy F. Geithner: We are in the midst of another wave of global economic and financial integration. ... Many of these implications are positive... In important ways, economic integration may have made the principal job of central banks easier, by contributing to productivity growth and reducing some sources of inflation pressure, at least during the transition when a large share of the working age population of the world is being brought into the market.

But the process of change in how economies and financial markets interact also complicates the task of central banks. ... In my remarks today, I will talk about some of the implications of these challenges for the conduct of monetary policy. I will focus on two features ... first, the behavior of forward interest rates in financial markets, and, second, the pattern of external imbalances. ...

When Alan Greenspan first used the term “conundrum” to describe the surprising behavior of forward interest rates, he was reacting to the decline in forward nominal rates over a period in which the Federal Open Market Committee was raising its federal funds target rate. ... The source of the relatively low level of nominal rates is still a matter of considerable debate. Part of the explanation lies in the decline in expectations of future inflation and uncertainty about future inflation. Part of the explanation may also lie in greater confidence that the secular decline in the variability of economic growth observed over the past two decades in the United States is likely to continue...

The other surprising feature of the current economic environment is the pattern of global imbalances, and the size and persistence of the U.S. current account deficit. ... If one were confident that observed imbalances simply reflected a more efficient allocation of the world’s stock of saving to its most productive uses, that relative prices adjust freely in response to changing fundamentals ..., then we might also reasonably expect these imbalances to resolve themselves through smooth and gradual adjustments in relative prices and flows of goods and services.

These conditions do not fully exist today. We do not yet live in a world of perfect capital mobility, one in which savings move across borders to their most productive use without constraint in the form of capital controls or without distortions affecting the behavior of private actors. Recognizing this is important to understanding both why the U.S. imbalance has grown as large as it has and, perhaps, more importantly why it has been financed with such apparent ease ...

The size of external imbalances, the capital flows associated with them, and the accompanying constellation of interest rates and exchanges rates reflect a range of factors... The relative importance of these factors is hard to assess, as is their likely persistence. And this complicates the task of understanding the implications for policy.

The challenge of explaining these anomalies is illustrated by considering some of the explanations now prevailing.

The decline of thrift in the United States is one common explanation. ... But this observation does not explain why that growth has not been accompanied by an increase in longer-term interest rates.

The robust productivity outlook for the United States relative to the rest of the world is consistent with an increase in the U.S. current account deficit ... But the present magnitude of the U.S. external imbalance seems difficult to reconcile with plausible estimates of future productivity and potential output growth.

The demographic shifts underway in the major economies seem to have contributed to an increase in demand for longer-dated fixed income assets to fund growing pension liabilities... but the effect of these changes seems likely to be small in comparison to the changes in the behavior of forward interest rates.

The rise in the current account surplus that is the counterpart to the U.S. deficit has focused much attention on the rise in measured savings relative to investment that has emerged in many economies. But the implications of this are ambiguous. If the rise in so-called excess savings principally reflected concern about future economic opportunities and weak investment demand, then this might imply a decline in future real interest rates. But the pessimism implied by this view is hard to reconcile with the relatively robust pattern of investment growth, particularly in those countries with some of the larger external surpluses. It is hard to reconcile with the fact that growth in aggregate demand globally has been reasonably strong... And it seems somewhat inconsistent with the rise in equity and other asset prices, the fall in credit risk premia, and the relatively low levels of uncertainty about the future reflected in measures of expected future volatility in many different types of financial instruments.

One feature of present conditions that is not captured by these explanations and that is likely to be playing a significant role in contributing to the combination of these large imbalances and relatively low forward interest rates is the pattern of exchange rate and monetary policy arrangements in the global economy today.

Even with the broad shift globally to more flexible exchange rates, a substantial part of the world economy now run monetary policy regimes targeted at limiting the variability in their exchange rate against the dollar, or a basket in which the dollar plays a substantial role. Sustaining that objective in the past several years has required a large accumulation of dollar assets. The scale of this activity has been particularly dramatic in parts of Asia. The significant rise in the earnings of the energy exporters, many of whom also run exchange rate regimes that seek to shadow the dollar, has also generated a substantial rise in investments in U.S. assets. A large share of the capital flows to the United States that have financed our current account imbalance come from these official sources.

These flows add to other sources of private demand for U.S. assets. At the margin, they put downward pressure on U.S. interest rates and upward pressure on other asset prices. Through this effect, the monetary policy regimes that prevail in parts of the world help explain at least part of the persistence of these anomalies. Recognizing that we live in a world where major exchange rates do not move freely against the dollar, means that the dollar is not as flexible as we tend to think. ...

The size of this effect is difficult to estimate with confidence. The ... collective flows from official sources are probably large enough to have some impact on U.S. interest rates. Research at the Federal Reserve and outside suggests that the scale of foreign official accumulation of U.S. assets has put downward pressure on U.S. interest rates, with estimates of the effect ranging from small to quite significant.

What does this mean for policy? Here are several implications.

First, this pattern of exchange rate and monetary policy arrangements and the associated scale of official intervention ... complicate our ability to assess the underlying economic conditions in our economies and to forecast the future... If the effects of these policies are large enough to alter or distort the relationship between asset prices and the underlying fundamentals in our economies, and this seems likely to be the case, then we can take less comfort from traditional relationships between those variables...

This ... phenomenon can act to mask or offset the effects of high levels of present and expected future government borrowing on interest rates, perhaps contributing to a false sense of reassurance that we can continue to run large structural deficits without risk of crowding out private investment and damaging future growth.

What might this mean for the conduct of monetary policy? To the extent that these forces act to put downward pressure on interest rates and upward pressure on other asset prices, they would contribute to more expansionary financial conditions than would otherwise be the case. And, if all else were equal, ... monetary policy in the affected countries would have to adjust in response; policy would have to act to offset these effects in order to achieve the same impact on the future path of demand and inflation...

Let me conclude by observing that a constellation of factors has aligned to produce the current combination of low world interest rates, low risk premia and large global imbalances. Most of these factors are outside the control of U.S. monetary policy, and we do not fully understand their implications for our economy and for policy. The process of global economic integration makes it ever more important that we work to improve our understanding of how this complex of global monetary arrangements affects our objectives.

    Posted by on Thursday, March 9, 2006 at 01:59 PM in Economics, Fed Speeches, International Trade, Monetary Policy | Permalink  TrackBack (0)  Comments (16)

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