William C Dudley: The global implications of diverging monetary policy
settings in advanced economies
Panel remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal
Reserve Bank of New York, at the Sixth High Level Conference on the International
Monetary System: Monetary Policy Challenges in a Changing World, Zurich, Switzerland,
12 May 2015.
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It is a pleasure to have the opportunity to participate in today's conference. In keeping with
this session's mandate, I will focus my remarks on the global implications of U.S. monetary
policy normalization - paying particular attention to the potential implications for emerging
market economies (EMEs). I put the focus here because these economies were greatly
affected in 2013 during the so-called "taper tantrum" and many of these economies have
been under stress from the weakness in global commodity prices. As always, what I have to
say today reflects my own views and not necessarily those of the Federal Open Market
Committee (FOMC) or the Federal Reserve.
But before I get to the implications for EMEs and what the Fed should do or not do to
mitigate the impact, a few words on the timing of normalization. To be as direct as possible: I
don't know when this will occur. The timing of lift-off will depend on how the economic
outlook evolves. Since the economic outlook is uncertain, this means the timing of liftoff must
also be uncertain.
At the same time, though, I can be clear about what conditions are needed for normalization
to begin. If the improvement in the U.S. labor market continues and the FOMC is "reasonably
confident" that inflation will move back to our 2 percent objective over the medium-term, then
it would be appropriate to begin to normalize interest rates.
Because the conditions necessary for liftoff are well-specified, market participants should be
able to think right along with policymakers, adjusting their views about the prospects for
normalization in response to the incoming data. This implies that liftoff should not be a big
surprise when it finally occurs, which should help mitigate the degree of market turbulence
engendered by lift-off.
Nevertheless, I think it would be naïve not to expect some impact. After more than six years
at the zero lower bound, lift-off will signal a regime shift even though policy would only be
slightly less accommodative after lift-off than it is before. I expect that this will have
implications for global capital flows, foreign exchange valuation and financial asset prices
even if it is mostly anticipated when it occurs.
Which leads to the key question I want to address in the remainder of my remarks: What
should the Federal Reserve do to minimize the impact?
Like other central banks, our monetary policy mandate has a domestic focus. Our monetary
policy actions, though, often have global implications that feed back into the U.S. economy
and financial markets, and we need to always keep this in mind.
From one perspective, the unconventional nature of monetary policy around the world adds
little that is fundamentally new to the challenges that face EMEs. Today's monetary policies
simply represent a way of easing that was necessitated by hitting the zero lower bound here
and elsewhere. Central bankers have managed differences across countries in cyclical
positions and policy stances many times in the past. This time should not be fundamentally
different.
But, from another perspective, we have less experience operating with unconventional
monetary policy, we have been in this regime for a long time and this creates more potential
uncertainties. These uncertainties put a premium on clear communication among central
bankers as well as between central bankers and market participants. In my view, an
important fact is that the large scale asset purchase programs undertaken in the United
States and elsewhere have dramatically shrunk the size of bond risk premia globally. This
new set of monetary policies affects financial asset prices in a different way compared to
changes in short-term interest rates, and we should be humble regarding what we claim to
understand about this distinction.
Looking ahead, it seems likely that markets will remain focused on those vulnerabilities that
they might have ignored prior to the taper tantrum in 2013. The greater premium on strong
fundamentals, policy coherence and predictability will likely remain. Although we will
undoubtedly experience further bumps in the road. I think we can remain generally optimistic
about the prospects for adjustment. But for this to occur, it will be important for market
participants to appropriately discriminate across countries, rather than treating EMEs as a
single group.
The good news is that many EMEs generally appear to be better equipped today to handle
the Fed's prospective exit from its exceptional policy accommodation than they were during
past tightening cycles. This reflects the fundamental reforms that EMEs have put in place
over the past 15 years, as well as the hard lessons learned from past periods of market
stress. Among the positives are:
• The absence of pegged exchange rate regimes that often came undone violently
during periods of acute stress;
• Improved debt service ratios and generally moderate external debt levels;
• Larger foreign exchange reserve cushions;
• Clearer and more coherent monetary policy frameworks, supporting what are now
generally low to moderate inflation rates;
• Generally improved fiscal discipline; and
• Better capitalized banking systems, supported by strengthened regulatory and
supervisory frameworks.
Of course, progress has not been uniform across EMEs, and more work remains to further
strengthen institutional structures in some countries. In particular, vulnerabilities remain in
several important EMEs, and some have been hit by the sharp adverse turn in their terms of
trade due to the recent fall in global commodity prices. Still, the fundamental improvements
I've cited leave many EMEs better positioned than in the past to weather those times in the
cycle when the external environment becomes more difficult.
The impact that changes in Fed policy can have beyond our borders has led to calls for us to
do more to internalize those impacts, or even further, to internationally coordinate
policymaking. As I've already noted, we are mindful of the global effects of Fed policy, given
the central place of U.S. markets in the global financial system and the dollar's status as the
global reserve currency. Accordingly, we seek to conduct monetary policy transparently and
based on clear principles. Promoting growth and stability in the U.S., I believe, is the most
important contribution we can make to growth and stability worldwide.
There is, of course, the argument that Fed policy has been too accommodative for too long,
creating risks for financial stability worldwide. Here, I think it's important to consider carefully
the counterfactual. Would countries beyond our borders really have been better off with a
weaker U.S. economy - an economy that might have required exceptional monetary policy
accommodation for a much longer period of time? The fundamental issue is whether U.S.
monetary policy has helped support our dual objectives of maximum employment in the
context of price stability, and whether this support is consistent with a healthy global
economy.
While explicit coordination looks neither feasible nor desirable, there may be more that
central banks in general, and the Fed in particular, could do to be better global stewards. As
an example, I would emphasize the importance of effective Fed communication. It is clear, in
retrospect, that our attempts in the spring of 2013 to provide guidance about the potential
timing and pace of tapering confused market participants. Market participants seemed to
conflate the prospective tapering of asset purchases with monetary policy tightening, and
pulled forward their expectations about the likely timing of liftoff and raised their expected
paths for policy rates. Lately, we seem to have done better: the tapering down of the Fed's
asset purchase program went smoothly and market participants now seem to share the
assessment embodied in the FOMC's March Summary of Economic Projections that lift-off is
likely to begin sometime later this year.
As you know, we've taken a number of steps in recent years to increase transparency and
improve our communications. This includes regular press conferences by the Fed chair
following FOMC meetings; the publishing of growth, inflation and short-term rate forecasts of
FOMC participants; and a concerted attempt to lay out the guideposts that the FOMC will
look at to assess progress toward our mandate. We also have explained in considerable
detail what tools we will use and how we will likely use them to ensure to ensure a smooth
lift-off.
A second area we have focused on is doing a better job safeguarding financial stability.
Simply put, we failed to act both early enough and decisively enough to stem the credit
excesses that spawned the financial crisis and the Great Recession. The U.S. was not alone
in this shortcoming, but given our position in the global financial system, we especially should
have done better. We've taken important steps through new legislative mandates and a
broader effort to rethink our regulatory and supervisory framework. In particular, systemically
important banking organizations must now hold amounts of capital and liquidity that are
better aligned with their risk profiles. Other changes have also been implemented, such as
central clearing of standardized OTC derivatives contracts, that should make the global
financial system more resilient and robust.
Although this effort remains very much a work in progress, I think it will enable us to avoid
repeating the mistakes of the past decade, and enable us to take a more proactive stance
toward mitigating potential future vulnerabilities. Of course, we at the Fed are not alone here.
Since the recent financial crisis, central banks worldwide have been engaged in a broad
rethinking of how to better fulfill their mandates.
Let me close with a final thought. The largest problems that countries create for others often
emanate from getting policy wrong domestically. Recession or instability at home is often
quickly exported abroad. Equally important, growth and stability abroad makes all our jobs at
home easier. This illustrates the externalities in the work we all do, with more effective
fulfillment of our domestic mandates helping to bring us collectively to a better place.
Thank you for your kind attention.