Laurence H Meyer: The global outlook and challenges facing central banks
around the world
Remarks by Mr Laurence H Meyer, Member of the Board of Governors of the US Federal Reserve
System, at the Edinburgh Finance and Investment Seminar, held in Edinburgh, Scotland, 24 May
2001.
* * *
While the pace of economic activity has slowed most sharply in the United States, growth has also
slowed in many countries. As a central banker, my focus will be on the challenges this slowdown
poses for monetary policymakers. These challenges vary around the world, reflecting differences in
country-specific shocks, the extent of the spillovers from these shocks, and the way individual
economies respond to common shocks. Monetary policy responses will also vary, even when
confronted by the same circumstances, because of differences in the structure of our economies,
differences in the mandates under which central banks operate, related differences in strategies that
guide the implementation of their policies, and limits on the ability of some central banks to engage in
expansionary policy.
Let me note, before proceeding further, that the views I am presenting here are my own. I am not
speaking for the Board of Governors or the Federal Open Market Committee.
The global slowdown
Before turning to the challenges faced by central banks, I want to set out my interpretation of the
sources of, and the global nature of, the slowdown. I will begin by identifying the country-specific and
common shocks that are at work and by considering the links that spread country-specific shocks
around the world.
The most obvious interpretation of the global slowdown is that it stems principally from a
country-specific shock and spillovers from that shock around the world - specifically, the sharp
slowdown under way in the United States. The principal traditional channel for spillover effects is
trade, with the sharpest spillovers in the current case to countries with the highest ratios of exports to
the United States relative to their incomes. The U.S. slowdown is, at the very least, a key ingredient in
the global slowdown. But let me offer several other interpretations, as alternatives or perhaps more as
complements.
Another explanation for the global slowdown is that there has been a coincidence of common adverse
shocks. The most obvious is the rise in oil prices. Though this shock affects all countries, the effect on
each country differs depending on the relative balance between oil production and consumption. This
is an example of how common shocks can have different effects across countries. Two other potential
common shocks are the global equity correction and the global retrenchment in high-tech investment.
The effects of these shocks would also differ across countries depending, for example, on the size of
market capitalization relative to gross domestic product for the equity correction and the share of
high-tech production to GDP for the retrenchment in high-tech investment.
The question with respect to the latter two shocks is whether they truly represent common shocks, or
instead are better understood as country-specific shocks with spillover effects elsewhere. In this case,
the shocks are a U.S. equity correction and a U.S. retrenchment in high-tech investment with
spillovers to equity markets and high-tech production around the world. Indeed, one may wonder
whether these two shocks - whether common or country-specific - are really independent. To an
important extent, it was a revision to tech-sector prospects that led equity prices lower.
A third source of the global slowdown is specific shocks that have occurred in other countries, in
addition to those hitting the United States. I mention this because I don't want the United States to
take all the credit. In particular, I believe that some of the credit should be shared with Japan and
perhaps also with the emerging Asian economies.
In the final analysis, the global slowdown is the result of some combination of country-specific shocks,
spillovers from the country-specific shocks, and truly common shocks. As I noted earlier, the shape of
the global slowdown will also be affected by the ability and willingness of the policymakers to respond
to that slowdown and the effectiveness of those responses. Some countries, for example, are already
benefiting from fortuitously timed fiscal stimulus this year and, in other cases, they are considering
fiscal packages. Monetary policy has responded in a timely fashion in the United States and some
other countries. In contrast, because macro policy options are more limited in Japan, the effects of
adverse common shocks or spillovers from other countries will be larger there than they would be the
if the Japanese had more flexibility to act.
Several important linkages help transmit country-specific shocks around the world. Models typically
focus on trade effects, particularly through the income-induced decline in imports by the country
slowing down. This spillover from the United States is clearly greatest in the current case for Mexico
and Canada, given that most of their exports go to the United States. The global retrenchment in the
high-tech sector has magnified the effect of the U.S. slowdown on Japan and in emerging Asia and
has added to their homegrown troubles. The high-tech retrenchment, on the other hand, has been less
important for the euro area and in Latin America.
The next linkage is through exchange rate movements. To a first approximation, exchange rate
developments do not affect the magnitude of the slowdown, but they do affect the distribution of the
slowdown around the world. Normally, we would expect the exchange rate in the country slowing
down to depreciate, more so if the country was aggressively cutting policy interest rates. And, we
would expect even more depreciation, if concerns about returns on capital were sharply depressing
equity prices. The income-induced decline in interest rates, and hence depreciation in exchange rates,
ordinarily plays the role of a built-in stabilizer in the country slowing down, but it also spreads the
slowdown around the world. One of the surprising features of recent experience has been the
continued appreciation of the dollar.
The appreciation of the dollar relative to the yen is perhaps not so surprising, given the troubles in
Japan, but the continued strength of the dollar in terms of the euro is a puzzle. The prevailing view
until late 2000 was that the U.S. dollar was strong against a broad group of currencies - and
especially against the euro and several other European currencies - because, to a large degree,
internationally mobile capital sought higher rates of return in the United States. Following this logic, a
slowing of the U.S. economy, a decline in expected profits, and a correction of asset prices should
have weakened the dollar.
I hesitate to offer a resolution to the puzzle of the depreciation that did not happen, given that I was
among those who expected a depreciation of the dollar under these circumstances. Nevertheless,
economists are much better at inventing explanations of past developments than predicting the future,
so here goes. The current slowdown in the United States is expected to be only temporary and capital
flows may be influenced more by differentials in long-term growth prospects than by shorter-run
cyclical fluctuations. The prospect of a return to robust growth in the United States that is above the
longer-run expected rate of growth in Europe may therefore continue to favor dollar-denominated
assets. Indeed, this may be reinforced by the fact that dollar-denominated assets have become so
much cheaper. Proponents of this view cite the continued need for significant progress in several core
euro-area countries on structural reform, especially in labor markets, as an indication that the euro
area may not be on the verge of an acceleration in productivity to close the growth gap with the United
States.
In any case, the continued appreciation of the dollar not only has dampened the normal offset from net
exports to a slowdown in the U.S. economy, but it also has reduced the spillover from the U.S.
economy to the euro area.
Even though exchange rate movements have thus far tended to damp rather than reinforce the
directtrade effects, the spillover from the U.S. slowdown to global growth seems to me larger than expected,
not smaller. It may simply be that it is difficult to disentangle the common shocks from the
country-specific shocks and that the other country-specific shocks and the common shocks are
strongly reinforcing the effect of the U.S. slowdown. But the apparent strength of the spillover from the
U.S. slowdown may also suggest the existence of important additional linkages beyond the income
and exchange rate induced changes in trade.
These additional linkages most likely arise directly and indirectly, at least in part, from the increasingly
tight connection among financial markets and the resulting synchronization of the global equity
correction, as well as from the effect of the global equity correction on consumer and business
confidence around the world. The tighter connection across global equity markets, in turn, may reflect
the growing importance of cross-border capital flows, of multinational firms, of foreign direct
investment, and of income flows from the accumulated stock of foreign direct investments.
For example, the gross cross-border investment position of the United States grew at an annual rate
of almost 19 percent per year during the second half of the 1990s - more than three times the growth
rate for nominal gross domestic product. And annual gross direct investment capital flows (inflows plus
outflows) have risen from 13⁄4 percent of GDP in 1993 to over 6 percent in 1999.1 The income flows
from accumulated direct investments have almost doubled between 1993 and 1999, although it
remains a little less than 11⁄4 percent of GDP. Finally, the importance of international firms has
increased over the same time period and the correlation among the share prices of international firms
is somewhat higher than for domestic firms.2
The global equity correction, in any case, means that negative wealth effects are shared around the
world. However, in most countries the stock market capitalization relative to GDP is decidedly lower
than in the United States, resulting in generally much more modest effects on aggregate demand for
given percentage declines in wealth. The exceptions to this rule are Canada and the United Kingdom.
One recurring theme has been the expectation that the euro area will be relatively insulated from the
effects of country-specific and common shocks. The euro area, for example, has only modest trade
links to the United States (minimizing the direct trade spillover from the United States), has benefited
from a depreciation of the euro (further mitigating any trade effect), has a relatively modest market
capitalization to GDP (minimizing either the spillover from the U.S. equity market correction or the
effect of the global equity correction), and has a relatively modest share of high-tech production to
GDP (minimizing the effect from the global retrenchment in high-tech investment). Nevertheless, while
these channels have muted the slowdown in the euro area, they have not eliminated it.
Now let me turn to the risks. The greatest risk, in my view, would arise from a sharper-than-expected
slowdown in the United States - either an outright recession or a more persistent period of very low
growth. A second risk - and this might well be part of the story behind the first - would be an
aggravation of the current slowdown in the United States and globally as slower growth triggered an
abrupt unwinding of pre-existing financial and other imbalances. This is the story that typically lies
behind more severe downturns. One important possible imbalance is a capital stock "overhang" in the
information technology sector, especially in the United States, but to a lesser degree in a few other
countries as well. In this case, the continuing retrenchment in high-tech investment could suppress
economic growth for a longer period.
Another possible imbalance that continues to receive a lot of attention around the world is the large
and still rising U.S. current account deficit. That deficit is, of course, simply the other side of the
massive capital flows to the United States to take advantage of the higher perceived return there. The
most benign adjustment would be for the euro area and other countries to benefit from an acceleration
in productivity, much as the United Sates has enjoyed. This would lead to a reversal of capital flows
and depreciation of the dollar, with income and relative price effects contributing to a moderation in the
U.S. current account deficit. But the adjustment would be more manageable in the context of higher
global growth, especially compared to an adjustment through a marked compression of imports,
should U.S. income decline.
A third global risk is the threat of financial instability in Japan. The renewed weakness of the Japanese
economy, coming at a time when macro policy options are limited, is putting additional pressure on the
Japanese banking and financial system. There is danger that a price will be paid - in Japan and
globally - for the failure to move more decisively to resolve these problems.
Another global risk is financial instability among emerging market economies. To date, jitters among
emerging market economies have reflected idiosyncratic factors, for example, in Turkey and in
Argentina. And there has been progress since the Asian financial crisis. In particular, most emerging
market economies have moved to flexible exchange rates, and many have higher official reserves as
well. Asian developing economies have current account surpluses instead of deficits and are less
reliant on short-term foreign borrowing. But unfinished business remains - specifically a failure to deal
decisively with financial sector weakness. Thus, a sharper slowdown among these countries could
trigger further financial difficulties.
The U.S. story
Given that the United States is playing such an important role in the global slowdown, and given that I
should be expected to know more about the United States than about the rest of the world, let me
spend a few minutes assessing the sources of the U.S. slowdown.
That story begins with the period of exceptional economic performance from the end of 1995 through
mid-2000. The driving force appears to have been a dramatic acceleration in productivity. After
averaging 11⁄2 percent per year from the early 1970s through the mid-1990s, underlying productivity
growth appears to have risen to 21⁄2 percent to 3 percent.
The productivity shock set off a complex, dynamic response. First, it boosted aggregate demand as
well as aggregate supply, indeed to the point that demand grew consistently faster than the new
higher rate of growth of potential supply throughout this period. This demand effect was due to the
simultaneous consumption and investment booms encouraged by the acceleration in productivity. The
investment boom was a response to the profit opportunities associated with innovations, particularly in
information technology. The consumption boom was due in part to a surge in equity prices, which was
also a response to expectations of higher profitability.
The acceleration in productivity also had a persistent, but ultimately temporary, disinflationary effect.
As wages responded with a lag to higher productivity growth, unit labor costs fell, profits rose, and
then competitive pressures passed along the lower costs to lower prices. In effect, the short-run
non-accelerating-inflation rate of unemployment (NAIRU) declined, allowing above-trend growth to
lower the unemployment rate without putting upward pressure on inflation.
But both the demand and disinflationary effects are temporary. Once productivity growth stabilizes,
even at a much-elevated level, these forces dissipate, growth slows, and pressures on prices might
intensify. At some point, therefore, the economy faces the potential for overheating and higher
inflation, at least if utilization rates remained at levels that are not sustainable in the longer run.
So why did the economy slow so sharply? First, it slowed because the Federal Reserve was
committed to achieving a better balance between the growth of aggregate demand and supply. By
mid-1999, the above-trend growth had lowered the unemployment rate to a 30-year low of 41⁄4 percent,
and there was concern that continued above-trend growth and still lower unemployment rates would
be inconsistent with maintaining steady inflation. This motivated the Federal Reserve's gradual
increase in the federal funds rate from mid-1999 to mid-2000, which cumulated to 175 basis points.
From my perspective, it was essential to slow the economy at least to trend, preventing further
increases in utilization rates. Indeed, some, including myself, believed it might be necessary to slow
the economy to slightly below trend for a while to further reduce the risk of inflationary imbalances. By
mid-2000, it appeared that growth was slowing to trend, so the Fed refrained from further tightening.
By the fall, it appeared that growth had slowed to modestly below trend, also an acceptable outcome,
in my view. So why did growth slow more sharply than that?
The explanation is, I believe, a coincidence of adverse shocks that reinforced the effect of tighter
monetary policy. These shocks included the rise in energy prices, an apparent stabilization in
productivity growth, an increase in credit-risk spreads in the bond market, a tightening of credit
standards at banks, the equity correction, and the retrenchment in high-tech investment. The latter
four developments were, in part, a response to monetary policy tightening and the associated
prospects of slower growth, but the magnitude of the responses were in each case out of proportion to
the degree of tightening. The outsized responses in equity prices and high-tech investment
presumably reflected an abrupt unwinding of pre-existing imbalances. Such a process is often an
important contributor to the severity of cyclical slowdowns.
Let me elaborate on the roles of productivity, equity prices and high-tech investment. The fate of these
variables is, of course, very interconnected, and they have collectively played a dominant role both
during the period of exceptional growth and the slowdown. Structural productivity growth appeared to
rise year after year, from the end of 1992 through the beginning of 2000. It was the continuing rise in
the growth rate of productivity that led to sustaining the temporary bonuses that took the form of higher
demand and lower inflation. Once productivity growth stabilized, these bonuses were destined to
dissipate, so the apparent stabilization of structural productivity growth in 2000 may have contributed
to both the slower demand and to some upward pressure on inflation.
The period of accelerating productivity was accompanied by a surge in equity prices - especially for
high-tech firms - and a frenzy of high-tech investment spending to take advantage of new profitable
opportunities. In each case, it appears - no doubt, more clearly in retrospect - that there were
speculative excesses that would, at some point, be corrected. In such a circumstance, monetary policy
could turn out to be a blunt instrument. It would have been an extraordinary achievement to fine tune a
slowdown to prevent or unwind an imbalance between aggregate demand and aggregate supply
without a risk of triggering an abrupt unwinding of these sectoral or market imbalances. Monetary
policy, therefore, had to be alert to the possibility that the slowdown would be more severe than
sought and that policy might, in such a circumstance, have to quickly reverse direction. This is
precisely what we have done.
Once demand slowed so sharply, the normal inventory cycle came into play. The inventory correction
may, in this case, be sharper and shorter than usual. Production in the "new economy" can respond
more quickly to signs of slower demand and emerging inventory building. But the slowdown has "new
economy" written all over it in other ways as well. The equity correction, for example, is a product, in
part, of excesses that accumulated during the economy's earlier adjustment to the productivity
acceleration. In this case, the decline in equity prices is more than a cyclical correction and more likely
a longer-lasting reappraisal of fundamental value and risk. And the retrenchment in high-tech
investment also reflects the downside of the frenzy of investment during the early stages of the
productivity acceleration.
None of these developments suggests that the productivity acceleration was a mirage. Indeed, most
observers are confident that productivity growth will remain elevated and that the continued pace of
innovations will, in time, contribute to a solid rebound in investment. Still, it is true that some will have
confidence in the structural productivity story only when it is tested by a cyclical decline. And the sharp
deterioration in equipment spending, concentrated in the high-tech sector, is likely to take a little edge
off structural productivity growth by slowing the contribution from capital deepening. Most important,
the drag on consumption from the negative wealth effect and on investment as the past excesses in
high-tech investment spending unwind will continue to be a drag on growth, even after the inventory
liquidation has run its course. But, as the effect of the recent easing takes hold, as fiscal stimulus
complements monetary stimulus, as energy prices perhaps decline a bit, and as the still-rapid pace of
innovation rekindles the appetite for new capital goods, growth should gradually recover, and the
economy should gradually return toward trend growth.
Challenges facing central banks around the world
Returning to the theme I opened with, monetary policies around the world can differ because of
differences in country-specific shocks, differences in how economies respond to common shocks,
differences in initial conditions, and differences in central bank mandates and strategies.
As I have already mentioned, the challenges faced by monetary policymakers in the United States
reflect the specific shocks in the United States and the unique initial conditions we faced. Before the
slowdown, output was arguably above potential, growth was above trend, and inflation was edging up.
These initial conditions motivated the monetary policy tightening. Because the Fed operates under a
dual mandate, we are responsible for promoting both price stability and full employment. We have
been quick and aggressive in responding to what we viewed as a threat of a slowdown that was
steeper than necessary to contain inflation, and the risks remain tilted in that direction. But we have to
remember both halves of the dual mandate. Given that labor markets remain tight, that inflation
remains above the rate that I would find acceptable over the longer run, and that core inflation has
been edging higher, attention must also be given to calibrating the easing to avoid overshooting in the
other direction in a way that ends up adding to price pressures as growth strengthens.
The challenge in the euro area is different in some important ways. First, as I noted, the euro area has
been insulated to a degree from the U.S. slowdown by its modest trade links with the United States,
and, in addition, faces smaller negative wealth effects and a more modest retrenchment in high-tech
investment than does the United States. However, considerable uncertainty remains about the
prospects for growth, and there are some indications that growth may be slowing more sharply than
expected, undoubtedly contributing to the recent easing by the European Central Bank. Second, the
initial conditions in the euro area were different than in the United States. Growth in the euro area was
also above trend, but output was below potential, though the gap was generally thought to be small
and closing. A slowing of growth to trend would mitigate the risk of overheating and would be an
acceptable outcome. Some, to be sure, have called for a more accommodative policy to take
advantage of, or test for, an acceleration in productivity growth. But central banks are cautious
creatures and need to see signs of higher productivity growth before moving to accommodate higher
growth in supply.
Perhaps the more interesting question is whether the differences in monetary policy between the Fed
and the ECB reflect not only differences in economic circumstances but also differences in how these
two central banks would respond to a similar set of circumstances. In particular, do differences in the
mandates under which the two central banks operate, and related differences in their strategies, also
contribute to different policy outcomes?
The ECB, like most inflation-targeting central banks, has a hierarchical mandate, different from the
dual mandate in the United States.3 Under hierarchical mandates, price stability or low inflation is
typically the primary objective and other objectives can be pursued only once the inflation objective
has been achieved. The ranking of objectives contrasts with a dual mandate, under which neither of
the two objectives takes precedence over the other.4 A second difference is that the ECB has an
explicit numerical inflation objective, whereas the Federal Reserve has a less precisely defined
objective of price stability.
However, what appear as differences in principle may not always lead to differences in practice. For
example, there may be little if any difference between the dual mandate and hierarchical mandate
when it comes to the response by monetary policymakers to demand shocks. Demand shocks move
output and inflation in the same direction. Under both mandates, policymakers may respond in the
same direction and with the same intensity. By stabilizing output relative to full employment, policy
under both mandates would also stabilize inflation.
Supply shocks, on the other hand, move output and inflation in different directions, so that it does
matter in this case whether or not policymakers directly respond to output gaps as well as deviations
of inflation from its target. But if the inflation target is a forward-looking or a medium-term objective,
policymakers will opt for a gradual return of inflation to its medium-term objective under both mandates
and the difference in policy responses under the two mandates will be diminished.
A second difference related to mandates and strategies is the precision and details of the
pricestability objective. The ECB has an explicit medium-term numerical inflation objective - inflation less
than 2 percent (but not less than zero) - while the Fed has a price stability objective but no explicit
numerical objective. One would expect that the more precise the price-stability objective, the less
flexibility policymakers will have to respond to demand or supply shocks. Indeed, this may be the
purpose of such a precise definition; that is, a more precise definition may promote greater credibility
about the commitment to price stability. While the ultimate determinant of credibility is surely
performance, in the absence of a historical record to support its credibility, the ECB may benefit
importantly from the credibility associated with its more precise definition. A less-precise definition, on
the other hand, allows more flexibility in the response to shocks.
Another aspect of the ECB inflation objective could be relevant. By defining the objective as inflation of
less than 2 percent, the ECB appears to have an asymmetric inflation objective. For the ECB, 2
percent is the ceiling, not a midpoint of acceptable inflation outcomes. If inflation (or more precisely,
the inflation forecast) rises above 2 percent, their strategy clearly dictates that monetary policy tighten.
But if inflation falls below 2 percent, the ECB is not under the same pressure to ease - at least until
inflation (or the forecast) threatens to fall below zero.
I believe the most important considerations behind the different monetary policies pursued by the
FOMC and the ECB are due to differences in circumstances - differences in initial conditions and
differences in the mix and intensities of supply and demand shocks. Nevertheless, the differences in
mandates and strategies likely also matter and lead to the two central banks, in effect, selecting
different points along the trade off between output variability and inflation variability - with the ECB
opting for lower inflation variability at the expense of somewhat higher output variability.
3
The ECB does not consider its policy as an inflation-targeting regime. It distinguishes its approach as a two-pillar strategy
that includes a focus on money growth as well as on a medium-term inflation objective. Still, its approach has much in
common with that of inflation-targeting regimes.
The Bank of Japan has a unique challenge. Initial conditions in Japan are very different from either the
United States or the euro area, and there are, in addition, severe limitations on the ability of monetary
policy to respond conventionally to downward shocks to demand.
Output is well below potential, there is ongoing deflation, and growth has been stagnant for a long
period. Monetary policy responded by lowering the nominal policy interest rate to zero, exhausting the
conventional opportunities for additional stimulus. Yet, the economy remains weak and further
monetary stimulus would be welcome. This is especially true given concerns about the sustainability of
their fiscal position - very large deficits and a very high and rising ratio of government debt to income.
A spillover from the United States and the global slowdown will therefore have a sharper effect on
Japan, to the extent that its monetary policy is unable to respond.
However, even once the policy rate has been driven to zero, there is a potential for additional stimulus
from monetary policy - from so-called unconventional operations, though there is considerable
uncertainty about their effectiveness. In principle, this additional stimulus can be imparted by monetary
policy operations in longer-term government or even private securities. The channels for the increased
stimulus work through the imperfect substitutability of assets and expectations about future monetary
policies. Such operations could lower long-term rates relative to short-term rates, lower private rates
relative to government rates, result in a depreciation of the yen, extend the expectations of lower
short-term rates over a longer period, and lead to expectations of higher inflation in the future.
The Bank of Japan recently changed its operating procedure - from targeting an overnight interest
rate to targeting the level of bank reserve balances at the Bank of Japan. In practical terms, this
marked a return to the zero interest rate policy by targeting the level of reserves that had been held
when they had been operating earlier at a zero interest rate. However, the new operating procedure
provides the flexibility to move toward a more aggressive monetization strategy, should it opt to move
in this direction, without having to change its operating strategy.
Monetary policymakers in Japan have appeared to be reluctant, to pursue a bolder monetization
strategy for several reasons. First, it might alter the incentives for fiscal policy, encouraging a delay in
fiscal consolidation. This highlights a fundamental policy problem in Japan - tensions between the rest
of government, principally the Ministry of Finance, and the independent central bank. The result is a
noncooperative solution that may preclude important opportunities for improved policy. Second, a
policy of aggressive monetization might have its principal stimulative effects through depreciation of
the yen. Without a consensus within Japan and a tolerance of such a development among Japan's
major trading partners, it would be best to proceed cautiously with such a policy. Third, a monetization
strategy alone is unlikely to sustain anything other than anemic growth in Japan. What is needed is a
combination policy that includes a real effort to resolve the banking problems, to deal with corporate
debt, and to open markets to domestic and international competition.