Donald L Kohn: Implications of globalization for the conduct of monetary
policy
Speech by Mr Donald L Kohn, Vice Chairman of the Board of Governors of the US Federal
Reserve System, at the International Symposium on "Globalisation, Inflation and Monetary
Policy", organised by the Bank of France, Paris, 7 March 2008.
* * *
Let me begin by saying that I agree with the thrust of John's remarks. He is right that
globalization has not fundamentally changed the way central banks should do business.
Although production chains and capital markets are more integrated across countries than
before, and gross trade flows now account for a larger share of gross domestic product
(GDP) in most nations, the dynamics of aggregate output and inflation remain at least
qualitatively the same. Accordingly, central banks should continue to conduct monetary
policy in the same forward-looking manner as they have for the past twenty years or so,
adjusting policy rates in response to current and expected future movements in output and
inflation, taking account of the lags in monetary policy. When exchange rates are free to
adjust, this general approach to policymaking has proven effective in fostering
macroeconomic stability over time in many countries.1
In my remarks, I will expand on another of John's points - namely, that monetary policy
making has been complicated by globalization, particularly by rising trade volumes and
increased capital market integration. That is true in several ways. For one thing, globalization
has likely made the domestic economy more sensitive to foreign shocks, so central banks
must now pay more attention to events around the globe. And, the integration of China and
other countries into the world market economy has expanded the scale and complexity of the
foreign developments that central banks must monitor. Finally, globalization has probably
made the link between policy actions and economic outcomes more uncertain by, among
other things, strengthening the role of the exchange rate in the monetary policy transmission
mechanism.
Recent increases in prices for oil and other commodities illustrate some of the complications
that globalization creates for policymaking. Those price increases have raised inflation
worldwide while accentuating already weakening growth prospects in some countries in
recent months. Commodity prices depend on a wide range of demand and supply factors,
and sorting out their various contributions can be difficult. In recent years, potential
constraints on the expansion of supply, especially of petroleum, have played a role. But in
addition, the emergence of China, India, and other industrializing Asian economies as major
consumers of oil and other raw materials has complicated the analysis, partly because these
countries exert such a strong influence on global markets and partly because the structure of
their economies is changing so rapidly.
Disentangling the various global forces influencing commodity prices can be useful in
assessing the implications of those prices for domestic output and inflation, and hence
monetary policy. For example, it matters whether a rise in oil prices results from demand
factors, such as stronger global real activity, or supply factors, such as a hurricane that shuts
down production. For an oil-importing country, a demand-driven price increase would have
less negative implications for domestic real activity than a supply-driven increase because an
expanding world economy would help boost demand for the country's exports. For the United
States, however, a rise in oil prices driven by stronger real Chinese activity would not
necessarily lead U.S. export volumes to rise substantially, given the low propensity of China
to import from the United States.
Policymakers focus on the inflation outlook, and so we need to consider what global forces
imply for the future when assessing the inflation consequences of rising commodity prices.
Will prices for crude oil and other commodities continue to rise rapidly in the face of robust
growth in China and other newly industrializing economies? Or do current prices on the spot
and futures markets already fully incorporate the likelihood of continued growth in those
economies, in which case prices would remain near their current level? In the first scenario,
climbing energy prices, for example, would continue to boost headline inflation directly and
would indirectly boost non-energy prices through higher costs of production; moreover, a
continuing rise in oil prices might potentially threaten the stability of long-run inflation
expectations and nominal wage demands. In contrast, a flattening out of oil prices would
restrain overall inflation, directly by stabilizing a key component of energy prices and
indirectly by ceasing to put upward pressure on inflation through pass-through and
expectational effects.
Because monetary policy has a limited ability to counter short-term price surprises, the
distinction between transitory and persistent influences on inflation from oil and other factors
is critical. If we were to project a continued significant rise in energy prices over the medium
run, we would need to factor that expectation into the outlook for overall inflation. Doing so
could have important implications for the stance of monetary policy - all the more so if we
expected rising energy costs to lead to higher inflation expectations and elevated wage
gains.
Still, a leveling out in oil prices seems the more likely scenario. Surprised as we have been
by the rapid, extended run-up in energy costs over the past few years, one would think that
the price of a storable commodity such as oil should already embody expectations of
continued rapid growth in the developing economies. However, the large run-up in spot and
futures prices in recent weeks indicates that market participants are still revising their views
of long-term demand-supply conditions. In these circumstances, policymakers must be
mindful of the uncertainties surrounding the outlook for commodity prices and the risk that
past or future increases in these goods could yet embed themselves in higher long-run
inflation expectations and a persistently faster rate of overall price increases.
Besides these complications, globalization has made the workings of the monetary policy
transmission mechanism more unpredictable. For one, the determination of asset prices is
now more dependent on conditions in financial markets worldwide, making the link between
domestic policy actions and movements in the prices of bonds or equities more uncertain.
For example, the correlation of quarterly changes in the federal funds rate with the variation
in U.S. Treasury yields has fallen from 0.6 before 1990 to 0.3 since then. To be sure, the
falling correlation probably reflects a variety of factors, possibly including more systematic
and predictable monetary policies. But global financial markets also seem to have played a
role; as Chairman Bernanke has pointed out, savings from abroad, especially Asia, appear to
have held down intermediate and longer-term U.S. interest rates from 2004 to 2006 even as
monetary policy was tightened. As we have seen in recent months, the increased integration
of financial markets has also facilitated the transmission and amplification across borders of
many shocks, such as changes in the perceived riskiness of certain assets and the
compensation required to hold them.
The role of the exchange rate is another complication that has only grown with globalization.
Of course, flexible exchange rates make it possible for central banks to achieve their
domestic economic objectives. But the exchange rate is a notoriously difficult asset price to
predict, and its response to any particular policy action is highly uncertain, as we found, for
example, in 2001, when aggressive rate cutting in the United States was accompanied by a
strengthening in the dollar. Even with an apparent decline in the pass-through of exchange
rates into import prices, the increase in trade volumes arising from globalization has
presumably boosted the relative importance of the exchange rate in the economy, thereby
strengthening an unpredictable factor in the monetary policy transmission mechanism.
Despite the increased openness of the domestic economy to foreign shocks and greater
uncertainty about the monetary policy transmission mechanism, economic volatility in the
United States and other advanced economies has declined. That stability may be
attributable, in part, to the increasing ability of global product and capital markets to buffer
the domestic economy against internal shocks. Because of globalization, net exports likely
absorb a greater proportion of downshifts in domestic spending, foreign competition helps
discipline domestic price increases, and - as a consequence of greater cross-border
holdings of assets - gains and losses on domestic assets are realized in part by foreign
investors. Together with the implementation of better monetary policies in many countries,
these particular aspects of globalization likely contributed to the "Great Moderation."
John addresses the question of whether greater economic integration has increased the
gains to be had from policy cooperation and coordination. We have seen an example
recently in which policy cooperation of a particular type seemed to pay dividends. In
December, simultaneous and in some cases coordinated actions by a number of central
banks to supply liquidity to banks apparently helped relieve stresses in interbank funding
markets. Coordination and cooperation were called for because banks today operate in many
markets simultaneously, and pressures in one market can readily spill over to others,
especially when the normal channels for arbitrage have been disrupted by financial turmoil.
The Federal Reserve and other central banks are examining the implications of this episode
for their methods of supplying liquidity and for responding to future interruptions in the flow of
liquidity across markets.
Successful coordination in the provision of liquidity raises the question of whether
appreciable gains might be had from coordination of monetary policies more generally. John
is skeptical, and so am I. Gains from formal policy coordination never seemed large, and it is
not clear that globalization has increased them appreciably. Policies agreed to under one set
of circumstances may no longer be appropriate when circumstances change, as they
inevitably will. Monetary policy should be able to adjust quickly to such changes; agreements
that must be renegotiated can tie policymakers' hands. That does not mean that no
circumstances exist in which coordinated monetary policy actions would be beneficial, but
such circumstances are probably quite rare. Ultimately, global stability depends on good
performance in individual countries, and the record of recent decades suggests that, in
general, good performance is most readily achieved when central banks focus on their own
mandates for domestic price stability and growth.