Governor Lael Brainard, spoke at the 2016 U.S. Monetary Policy Forum, New York, New York. The speech highlighted that whilst there was a phase when different economic centres were diverging, now there are more common elements, including low growth, low interest rates and low inflation. Global shocks are being transmitted via the financial system, creating volatility and spillover effects.
To the extent that we are observing limited divergence in inflation outcomes and less divergence in realized policy paths than many anticipated, this could be attributable to common shocks or trends that cause economic conditions to be synchronized across economies. The sharp repeated declines in the price of oil have been a major common factor depressing headline inflation and are also likely feeding into low core inflation, although to a lesser extent. As noted previously, these price declines have led headline inflation across the globe to behave quite similarly over this time period. Even so, most observers expect this source of convergence in inflationary outcomes to eventually fade and thereafter not affect monetary policy paths over the medium term.
In contrast, a more persistent source of convergence may be found in an apparent decline in the neutral rate of interest. The neutral rate of interest–or the rate of interest consistent with the economy remaining at its potential rate of output and inflation remaining at target level–appears to have declined over the past 30 years in the United States and is now at historically low levels. Similarly, longer-run interest rates appear also to have fallen across a broad group of advanced and emerging market economies, suggesting that neutral rates are at historically low levels in many countries around the world and near or below zero in the major advanced foreign economies. Although the reasons for the declines in neutral rates are not perfectly understood and may differ across countries, there are some common drivers, such as slower productivity and labor force growth and a heightened sensitivity to risk.
The very low levels of the shorter run neutral rate reflect in part headwinds from the crisis that are likely to dissipate over time. However, if many of the common forces holding down neutral rates prove persistent, then neutral rates may remain low through the medium term, implying a shallower path for policy trajectories.
The global economy is also experiencing a downshift in emerging market growth momentum led by China, which may prove somewhat persistent. Whereas earlier in the recovery there was a striking divergence between the relatively buoyant growth in major emerging economies and depressed growth in advanced economies, lately the extent of divergence has diminished noticeably. China is undergoing a challenging set of economic transitions. Trend growth has slowed substantially and is expected to slow further, and the composition of growth is shifting away from resource-intensive manufacturing and exports toward a greater share for consumption and services. China’s investment has slowed sharply recently after accounting for nearly one-third of global investment over the past three years and about one-half of global consumption in certain metals such as iron ore, aluminum, copper, and nickel. Commodity exporters and close trading partners in Asia will be most affected, but the changes in the composition and rate of growth in a country that has accounted for about one-third of the growth in world output and trade will likely ripple through the global economy much more generally.
Amplified Spillovers
Of course, policy divergence among major economies could be limited by rapid and strong transmission of foreign shocks across borders. In particular, although the U.S. real economy has traditionally been seen as more insulated from foreign trade shocks than many smaller economies, the combination of the highly global role of the dollar and U.S. financial markets and the proximity to the zero lower bound may be amplifying spillovers from foreign financial conditions. By one rough estimate, accounting for the net effect of exchange rate appreciation and changes in equity valuations and long term yields, over the past year and a half, the United States has experienced a tightening of financial conditions that is the equivalent of an additional increase of over 75 basis points in the federal funds rate.10The transmission of divergent economic conditions across borders typically occurs though a couple of different channels. First, a decline in demand in one country reduces its demand for imports from other countries. Second, the fall in economic activity would be expected to trigger a more accommodative monetary policy, which helps offset the effect of the shock by both supporting domestic demand and weakening the exchange rate. The weaker exchange rate in turn leads domestic consumers to switch their expenditures away from more expensive foreign imports to cheaper domestic products while increasing the competitiveness of exports. The extent to which monetary policy offsets the shock by dispersing it to trade partners as opposed to strengthening domestic demand depends on the responsiveness of domestic demand relative to the exchange rate. The exchange rate channel, by raising the price of imports in domestic currency, also pushes up domestic inflation and exerts downward pressure on foreign inflation.
The strength of spillovers across countries and the extent to which that affects policy divergence across countries depend on a foreign economy’s openness to these different channels. The recent experience of Sweden suggests that for highly open economies, the effect of foreign shocks can be extremely powerful. Sweden’s economic growth has been relatively rapid recently, reaching nearly 4 percent over the most recent four quarters. Moreover, the employment gap is estimated to be nearly closed, and there are signs of financial excess in the housing market. In ordinary times, these conditions would be consistent with relatively tight monetary policy. However, inflation has run persistently well below the central bank’s 2 percent inflation target. Given the relative openness of Sweden’s economy, moving the inflation rate back up to target has been greatly complicated by the sensitivity of Sweden’s exchange rate and financial conditions to developments in the euro area, where domestic economic conditions are consistent with much more accommodative policy. As a result, the Riksbank has been pursuing extremely accommodative monetary policy, most recently lowering the interest rate on deposits to minus 0.5 percent and authorizing the Governor and Deputy Governor to intervene in foreign currency markets.
Even in the much larger United States economy, with imports accounting for a little over 15 percent of gross domestic product (GDP), spillovers can be quite strong, in part reflecting the international role of U.S. financial markets and the dollar. Since the middle of 2014, with a reassessment of demand growth in the euro area and subsequently in emerging markets and other commodity exporters, the real trade-weighted value of the dollar has increased nearly 20 percent. As a result, in 2014 and 2015, net exports subtracted a little over 1/2 percentage point from GDP growth each year, and econometric models point to a subtraction of a further 1 percentage point this year.12 In addition, the dollar’s appreciation is estimated to have put significant downward pressure on inflation: Non-oil import prices fell 3-1/2 percent in 2015, subtracting an estimated 1/2 percentage point from core PCE inflation.
Financial channels can powerfully propagate negative shocks in one market by catalyzing a broader reassessment of risks and increases in risk spreads across many financial markets. Since the beginning of the year, U.S. financial markets have reacted strongly to adverse news on emerging market growth, even though the news on the U.S. labor market has remained positive. In this regard, although China’s direct imports from the United States are modest, uncertainty about changes to its exchange rate system and financial imbalances, together with changes in the composition of its growth, have had broader global spillovers that may pose risks to the U.S. outlook.
Recent events suggest the transmission of foreign shocks can take place extremely quickly such that financial markets anticipate and indeed may thereby front-run the expected monetary policy reactions to these developments. It also appears that the exchange rate channel may have played a particularly important role recently in transmitting economic and financial developments across national borders. Indeed, recent research suggests that financial transmission is likely to be amplified in economies with near-zero interest rates, such that anticipated monetary policy adjustments in one economy may contribute more to a shifting of demand across borders than a boost to overall demand. This finding could explain why the sensitivity of exchange rate movements to economic news and to changes in foreign monetary policy appear to have been relatively elevated recently.
Financial tightening associated with cross-border spillovers may be limiting the extent to which U.S. policy diverges from major economies. As policy adjusts to the evolution of the data, the combination of heightened spillovers from weaker foreign economies, along with a lower neutral rate, could result in a lower policy path in the United States relative to what many had predicted.
Policy
In circumstances where many economies face common negative shocks or where negative shocks in one country are quickly transmitted across borders, it is natural to consider whether coordination can improve outcomes. Under certain conditions–such as flexible exchange rates, deep and well-regulated financial markets, and flexible product and labor markets–policies designed for the domestic economy can readily offset any spillovers from economic conditions abroad, and policies designed to address domestic conditions can achieve desirable outcomes both within the national economy and more broadly.In some circumstances, however, cooperation can be quite helpful. If, for example, economies face a common challenge, coordination can communicate to markets that policymakers recognize the challenge and will work to address it. Reducing uncertainty about the direction of policy and addressing concerns about policies working at cross-purposes can boost the confidence of businesses and households. With intensified transmission effects in the vicinity of the zero lower bound, there is a risk that uncoordinated policy on its own could have the effect of shifting demand across borders rather than addressing the underlying weakness in global demand. The difficult start to the year should be a prompt for greater policy coherence and clarity. This might be a good time for policymakers to reaffirm their commitment to work toward the common goal of strengthening global demand.
Similarly, with anemic global demand and interest rates near zero, in some economies there is scope for monetary policy to be more effective with fiscal policy working in the same direction. With potential growth and nominal borrowing rates both low, public investment that increases potential in the longer run and demand in the shorter run could make an important contribution. A joint determination by policymakers across major economies to better deploy policy tools to provide support for global demand could be beneficial.
