Alberto G Musalem: International spillovers and policies
Remarks by Mr Alberto G Musalem, Executive Vice President of the Integrated Policy
Analysis Group of the Federal Reserve Bank of New York, at the People's Bank of
ChinaFederal Reserve Bank of New York Joint Symposium, Hangzhou, Zhejiang, China, 15 Mach
2016.
* * *
Good morning. Thank you for the opportunity to speak here in Hangzhou about the important
theme of international spillovers. By exchanging perspectives and experiences we can forge
relationships and a shared understanding that can lead to better economic outcomes. I will
focus mostly on the interaction of international spillovers with policy frameworks within and
across countries. I will do this from the vantage point of a domestic economy experiencing
foreign spillovers. I will then briefly turn to considerations from a U.S. perspective. As always,
my remarks reflect my own views and not necessarily those of the Federal Reserve Bank of
New York, the Federal Open Market Committee (FOMC), or the Federal Reserve System.1
International spillovers encompass a broad topic with respect to their sources and channels.
Before narrowly focusing on monetary sources and associated channels, it seems
appropriate to first take a broader view of the various sources. Foreign spillovers can
emanate from monetary, fiscal, regulatory, currency or trade policies. Spillovers can also
arise from endogenous productivity changes, from financial stability developments, and from
a global financial cycle.2
The Mundell-Fleming logic remains relevant for thinking about policy options of open
economies. It provides lessons on channels of transmission, basic tradeoffs across
objectives, and the effectiveness of policy responses.3 The channels of macroeconomic and
financial transmission among open and interdependent economies occur through the current
account of the balance of payments, the capital account, or both. From the vantage point of
the domestic economy, there are three main channels of transmission: the exchange rate;
the external demand; and the interest rate or risk-premia channel. The last can be more
broadly defined as the financial conditions channel.
The intensity of transmission of spillovers will depend on the monetary policy, currency policy
and the real and financial openness of the economy being affected by external
developments. Other relevant characteristics include the flexibility of labor and product
markets; the depth, safety and soundness of the financial system; and the economy's
position as an international creditor or debtor.
The Mundell-Fleming framework suggests that a country with a high degree of capital
mobility and a flexible currency will be in a favorable position to use monetary policy to attain
its internal growth and inflation objectives. When foreign interest rates increase and financial
conditions tighten, changes in relative prices brought about by currency fluctuations can help
to absorb the external shocks. The positive expenditure switching effect from currency
depreciation improves the trade balance and supports demand. It is sufficiently larger than
the negative investment demand effect from higher interest rates, such that internal balance
is attained and monetary policy is able to pursue domestic inflation and growth objectives.4
Different policy options are available to a country with a high degree of capital mobility and a
preference for currency stability. A country may prefer currency stability as an effective
nominal anchor, or because of concerns about the broader uncertainties associated with
currency volatility. Regardless of the reason and because the exchange rate is not available
to absorb external shocks, this country will be in an unfavorable position to achieve domestic
macroeconomic objectives by using monetary policy. Instead, monetary policy is aimed at
external adjustment. Tighter foreign monetary policy and financial conditions need to be
validated by tighter domestic monetary policy to maintain currency stability. With domestic
monetary conditions effectively imported from abroad, they may sometimes conflict with
domestic growth and inflation objectives. Simply put, currency stability is prioritized.
These policy considerations are summarized in the well-known international policy trilemma.
It says that a country cannot simultaneously maintain independent monetary policy focused
on domestic objectives, a high degree of capital mobility, and currency stability. Any two of
these regime characteristics can be chosen, but not all three. While the trilemma suggests
sharp tradeoffs, additional policy tools can soften the tradeoffs.
Fiscal policy is one tool that serves this purpose. When foreign credit conditions tighten,
expansionary fiscal policy can allow a country with a high degree of capital mobility, and a
policy preference for currency stability, to effectively manage towards domestic
macroeconomic objectives and internal balance. In fact, fiscal policy can also be used to
rebalance the composition of demand towards the desired mix of investment and
consumption.
Softer tradeoffs than implied by the trilemma are suggested by some of the empirical
evidence on interest rate co-movements. For example, there is ample evidence that
domestic short-term interest rates become progressively less correlated with short-term
interest rates in large foreign countries, and that monetary policy is more autonomous, as
countries move from high capital mobility to low capital mobility, and from rigid currencies to
flexible currencies.5
Using foreign exchange reserves to support currency stability is unlikely to be as effective in
enabling the country to attain domestic growth and inflation objectives. If losses of foreign
reserves are not sterilized, the effect will be similar to that of domestic monetary tightening,
and as already discussed, might work against domestic growth and inflation objectives. If
reserve losses are sterilized and the underlying cause of capital outflows is not addressed,
reserves losses can be persistent.
Macroprudential policy provides an additional tool that can add degrees of freedom and help
soften the tradeoffs of the trilemma. Macroprudential policy can potentially temper spillovers
by modulating the type of buildup of financial imbalances that contributed to the Asian crisis
of 1997, countless other emerging market crisis, the global financial crisis of 2008 and the
subsequent euro area crisis of 2011. Progress continues to be made in designing
macroprudential policy frameworks, in definition of objectives, and in developing appropriate
instruments, calibration and communication.
Capital flow management can be viewed as the part of the macroprudential toolkit that
operates across borders. Over the last five years, capital flow management has received
increased attention, first in managing inflows and, more recently, in managing outflows.6 A
consensus has emerged that capital flow management can be useful as part of a broader set
of policy tools. In fact, the effectiveness of capital flow management may be limited if not
appropriately supported by monetary, fiscal, exchange rate and prudential policies, or the
warranted macroeconomic adjustment. Also, capital flow management practices that are
transparent, temporary, and targeted seem to work best.
Spillovers from foreign countries are not confined only to conventional monetary policies, nor
is the U.S. the sole source of transmission. There also is evidence that the unconventional
monetary policies of the ECB and the BOJ have spilled over onto the U.S. yield curve and
broader financial conditions.7 This is interesting because all three monetary areas share the
characteristics of flexible currencies and capital mobility.
I will now conclude with a few related comments from the U.S. perspective.
The Fed's statutory mandate, like that of other central banks, is domestic. The Federal
Reserve Act states that the Fed should "promote effectively the goals of maximum
employment, stable prices, and moderate long-term interest rates". Within this mandate,
there are good reasons to consider the international effects of monetary and regulatory
policies. The U.S. economy and the economies of the rest of the world have important
feedback effects on each other, and adverse international spillovers can harm U.S.
prosperity.
Like other central banks, the Federal Reserve can help promote global prosperity and
stability, by promoting growth and stability at home. The FOMC has taken a number of steps
in recent years to increase transparency and improve communications, to effectively convey
policy intentions to market participants and policymakers. The Fed has also made
considerable progress in strengthening the safety and soundness of the U.S. financial
system, through improved regulation and supervision of banks and a broader group of
systemically important institutions. A stronger U.S. banking system better protects against
future shocks, provides a more solid foundation for domestic growth, and therefore also
enhances prospects for growth and financial stability abroad.
I look forward to a discussion with fellow panelists and also to engaging with conference
participants over the next two days.
Thank you for your attention.
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