Lael Brainard: Unconventional monetary policy and cross-border
spillovers
Speech by Ms Lael Brainard, Member of the Board of Governors of the Federal Reserve
System, at the 16th International Monetary Fund Jacques Polak Research Conference
"Unconventional Monetary and Exchange Rate Policies", Washington DC, 6 November 2015.
* * *
Among students of central banking, the Great Recession will be remembered in part for the
monetary policy innovation it prompted. Since 2008, we have seen several episodes of
extreme financial conditions in major economies. In many countries, monetary policy has
shouldered a large share of the policy response. Debt-deleveraging dynamics and
disinflationary pressures have confronted policymakers in several economies with the classic
challenge of providing accommodation when constrained by the zero lower bound. In
contrast to the Great Depression, a number of central banks have found the "courage to act,"
which has led to important policy innovation. While it will take many years for rigorous
research to distill the lessons from this period, I will offer a few preliminary observations.1
The effectiveness of unconventional monetary policy
For much of the period since 2008, many economies, including the United States, the United
Kingdom, Switzerland, the euro area, and Japan, have been at or near the zero lower bound.
Many economies have experienced depressed aggregate demand and large and persistent
gaps between output and potential, which have led to significant reductions in the level of
policy rates in order to achieve full employment and target inflation. Moreover, the neutral
level of short-term risk-free rates looks to be much lower now in many countries than it had
been previously. A lower neutral rate raises the likelihood that the requisite monetary
accommodation when using conventional tools alone implies setting the nominal policy rate
below zero. With constraints on moving nominal interest rates significantly below zero,
central banks have looked to unconventional policy, such as asset purchases.
The evidence suggests that unconventional monetary policy can be effective at overcoming
the limitations on policy at the zero lower bound by operating through channels broadly
similar to conventional monetary policy. A number of studies have suggested that the forward
guidance and large-scale asset purchases conducted by the Federal Reserve boosted the
levels of employment and inflation at a time when the level of short-term interest rates was
constrained by the zero lower bound. For example, Engen, Laubach, and Reifschneider
estimate that the Federal Reserve's forward guidance and asset purchase programs may
have lowered the unemployment rate by as much as 1-1/4 percentage points and increased
the level of inflation by 50 basis points.2
While conventional policy operates directly on the current and expected future path of
overnight interest rates, and thereby indirectly influences longer-term interest rates, asset
purchases are directly targeted at lowering yields on longer-term securities, which continue
to have positive interest rates. In the so-called portfolio balance effect, the asset purchases
reduce the supply of long-term Treasury and agency securities available in the market, which
leads investors to bid up the price of remaining securities, thus lowering yields across a
range of financial assets. Despite this difference, the channels through which asset
purchases affect the economy appear similar to those of conventional monetary policy. The
resulting reduction in interest rates spurs investment and purchases of consumer durables,
lowers the exchange rate, and increases the prices of risky assets, such as equities.
In addition, many have also emphasized an indirect effect through a "signaling channel." By
helping to shape expectations about the expected future path of the federal funds rate, asset
purchases help reinforce forward guidance. Thus, asset purchases can affect longer-run
interest rates by lowering the expected path of short-term rates as well as by reducing the
term premium of long-duration securities.3
Spillovers from unconventional monetary policy
Turning to the cross-border effects, just as unconventional policy appears similar to
conventional policy in its domestic effects, the analysis so far suggests that spillovers from
unconventional monetary policy work through the same three channels as conventional
monetary policy does.4 First, when monetary policy in one country responds to a negative
economic shock by easing, this action helps support domestic demand, which in turn will
likely lead to greater demand for the exports of foreign countries. Second, monetary policy
easing can also lead to a depreciation of the country's foreign exchange rate, which switches
domestic expenditures away from foreign exports. Finally, it eases conditions across financial
markets in that country, which can lead to financial easing in foreign markets when global
financial markets are tightly integrated.
The spillovers are likely to be more positive the greater the expansion of domestic demand
relative to the expenditure switching effect through the exchange rate and the greater is the
easing of financial conditions. The magnitude of the relative cross-border effects from each
of these three channels will depend on the size of the country that is easing monetary policy
as well as its relative weight in international financial markets.
Since 2008, changes in the stance of monetary policy in major economies have often elicited
strong reactions in other economies. Whether the global spillovers from changes in monetary
policy were viewed as benign or challenging depends on the relative strength of the three
transmission effects described earlier, the relative divergence of conditions in foreign
economies, and the flexibility of their monetary policy tools to offset divergent spillovers.
To illustrate this point, let's start with a case where the effect of easing through
unconventional means was broadly welcomed. From 2008 through 2009, the Federal
Reserve eased policy through cuts in its policy rate and through large-scale asset purchases.
That easing came in the context of a widespread global slump and severe strains in global
3
A number of observers have suggested that the market and macroeconomic effects of the initial asset
purchase programs announced at the most intense period of the financial crisis may have been larger than the
programs announced later in the recovery. The initial programs were important in bolstering confidence
broadly and supporting liquidity in financial markets. The later asset purchase programs, particularly the
flowbased program whose duration was tied to a substantial improvement in the outlook for the labor market, were
important in signaling that the Federal Reserve was committed to taking all actions necessary to achieve its
mandated objectives.
4
For example, see David Bowman, Juan M. Londono, and Horacio Sapriza (2014), "U.S. Unconventional
Monetary Policy and Transmission to Emerging Market Economies (PDF)," International Finance Discussion
Papers 1109 (Washington: Board of Governors of the Federal Reserve System, June); John H. Rogers,
Chiara Scotti, and Jonathan H. Wright (2014), "Evaluating Asset-Market Effects of Unconventional Monetary
Policy: A Cross-Country Comparison (PDF)," International Finance Discussion Papers 1101 (Washington:
Board of Governors of the Federal Reserve System, March); Joshua Hausman and Jon Wongswan (2011),
"Global Asset Prices and FOMC Announcements," Journal of International Money and Finance, vol. 30 (April),
pp. 547-71; and Reuven Glick and Sylvain Leduc (2013), "The Effects of Unconventional and Conventional
U.S. Monetary Policy on the Dollar (PDF)," Working Paper Series 2013-11 (San Francisco: Federal Reserve
Bank of San Francisco, May).
financial markets, and in these circumstances it had significant positive international
spillovers. The boost to domestic demand likely outweighed any effect via the exchange rate
and contributed to an easing of U.S. and global financial conditions. Those positive spillovers
were reinforced by widespread easing of conventional monetary policies by central banks
across the globe in response to the depressed state of their economies.
In contrast, in 2010 and 2011, when the Federal Reserve undertook its second round of
large-scale asset purchases, the global reaction was mixed. By that time, several emerging
market economies were experiencing economic conditions close to full employment and
strong credit growth. For many of the countries with divergent economic conditions, the
combination of a market-based exchange rate and a firmly anchored monetary policy
framework oriented around domestic objectives was sufficient to offset spillovers.
Others, however, saw the increased capital inflows associated with the divergence of
conditions as presenting problems for the management of their own economies. One country
in this category was China, which was experiencing an investment-led expansion
accompanied by credit expansion.
Separately, several emerging market economies with relatively flexible exchange rates,
particularly those experiencing expansions because of strong commodity prices, saw risks
from the combination of capital inflows and upward pressure on exchange rates. Elevated
inflows of foreign capital can present challenges in circumstances where prudential oversight
and control of financial markets are not fully developed. Thus, countries such as Brazil
worried that heavy capital inflows could lead to an undesirable loosening of credit conditions
and leave the economy vulnerable to rapid reversals.
In the past two years, we have seen these concerns play out in reverse. During the "taper
tantrum" in 2013 and again in recent months, an increase in expectations of policy
divergence in the United States confronted economic policymakers in emerging markets with
capital outflows and financial tightening against a backdrop of weakening economic growth
and financial imbalances. For these economies, while exchange rate depreciation can help
offset weaker demand for exports and tighter financial conditions, it also puts upward
pressure on inflation and may create problems for corporations with considerable
foreigncurrency denominated debt. In the case of China, a previously set course of tying the
renminbi to the U.S. dollar led to an appreciation of the currency from mid-2014 to mid-2015
in an economy that was already slowing. Attempts to offset the effects of this undesired
appreciation have had mixed results.
Discontinuity around the Zero Lower Bound
If the research is correct in concluding that the channels for spillovers do not differ, these
episodes should have played out little differently for conventional policy changes than they
did for unconventional policy. That raises the question of why announcements of new policy
actions around the zero lower bound have elicited such intense reactions. The launch of the
Federal Reserve's second asset purchase program in November 2010, for instance, sparked
a blistering response from several foreign policymakers. One foreign finance ministry official
was famously quoted as denouncing it as "clueless," while others dubbed it the start of a
"currency war." Officials from emerging markets with managed exchange rates argued that
the United States "has not fully taken into consideration the shock of excessive capital flows
to the financial stability of emerging markets."5
The reaction was just as striking - albeit in the opposite direction - when the Federal
Reserve first announced its intention to taper asset purchases in 2013. The taper talk
coincided with a broad reassessment of prospects in several large emerging markets in
which some combination of financial, fiscal, and external imbalances had been building for
some time. Spillovers through financial channels were immediate despite the fact that the
anticipated reduction in asset purchases in the United States was expected to take place
gradually sometime in the future.
My conjecture is that the widespread perception that unconventional monetary policy has
large and disruptive spillovers may be a reflection of the discontinuity associated with
discrete policy changes at the zero lower bound, along with greater uncertainty about the
policy reaction function, rather than differences in the underlying channels of transmission.
When policy rates are in a range comfortably above the lower bound, most of the major
central banks confront a relatively narrow range of options in a relatively familiar framework
of decisionmaking and communications. By contrast, over the past six years, decisions by
major central banks to initiate asset purchases have neither been seen nor communicated as
incremental adjustments, but instead as bold new initiatives whose cumulative intended
scale, duration, or objective were announced at the outset, often against the backdrop of a
public debate about the efficacy and appropriateness of various policy options.
For example, in its first two asset purchase programs the Federal Reserve committed to
buying $1.7 trillion and $600 billion of assets, respectively, while in the subsequent
flowsbased program it committed to continuing monthly asset purchases until the outlook for the
labor market had met a target for substantial improvement. Cumulative asset purchases
averaged a little over $1 trillion per program, which econometric estimates suggest
contributed to sizable reductions in term premiums embedded in long-term yields and a
downward shift in the expected path of the federal funds rate. Similarly, in 2013, the Bank of
Japan announced asset purchases at an annual pace of about 50 trillion yen and committed
to continuing these purchases until inflation had moved up to 2 percent. The European
Central Bank, at the beginning of this year, committed to buying 60 billion euros of assets
each month at least through September of next year, or until inflation is on a path to get to
close to 2 percent. In all of these cases, the policy actions themselves were large and
designed to generate a significant easing in overall financial conditions, and the
announcement effect likely was amplified because the policy reaction function around the
zero lower bound was not well known and hence was difficult to anticipate.
International coordination of unconventional monetary policy
The intense debates over cross-border spillovers of unconventional monetary policy during
the crisis naturally elicited calls for global coordination of monetary policy to avoid
beggarthy-neighbor actions that could undermine growth globally. Recognizing the practical
limitations of such proposals, in 2013, the Group of Seven (G-7) instead adopted a more
circumscribed but achievable set of commitments. Each member committed that its monetary
policy settings - unconventional as well as conventional - would be oriented to meeting its
"respective domestic objectives using domestic instruments," and "not target[ing] exchange
rates."6 This agreement ensured that actions in the major advanced economies would be
designed to provide accommodation targeted to supporting domestic demand, which would
in turn support global demand - in contrast to classical demand-sapping beggar-thy-neighbor
policies designed to shift demand by weakening the exchange rate. The agreement to use
domestic policy instruments to support domestic output and inflation objectives is likely, on
net, to be an important constraint against beggar-thy-neighbor policies, especially in the less
charted territory of unconventional policy.
Implications for the United States
Finally, it is worth considering what this implies for the United States. While traditionally the
United States is viewed more as a source than a recipient of cross-border spillovers, recent
events have demonstrated that U.S. economic and financial conditions can be sensitive to
spillovers from advanced economies as well as from major emerging market economies.
Over the past two years, we have seen divergences emerge among major economies in
domestic growth prospects and the expected direction of monetary policy. Earlier in this
period, the focus was on heightened deflationary risks in Japan and the euro area. The policy
response to these pressures and the anticipated divergence between the policy trajectories
in these economies and the United States contributed to a 10 percent real appreciation in the
dollar against a basket of currencies through the spring of this year.
More recently, growth projections have been marked down for emerging market economies,
which previously had been an important source of global growth. Increased recognition of the
risks to the outlook for major emerging market economies pushed the dollar up further to
15 percent above its level last summer and contributed to a more general tightening of
financial conditions over the summer. Much of the focus of investors and policymakers
around the world has been on China, where the buildup of past property bubbles, and
morerecent stock market, bubbles, together with a steep run-up in business debt levels and
questions about the policy framework, have raised concerns. In turn, growth has slowed both
in many commodity-exporting countries whose exports are sensitive to Chinese demand as
well as many non-commodity-producing East Asian economies that are tied to China through
trade and investment and are important destinations for U.S. exports.
The feedback loop between market expectations of divergence between the United States
and our major trade partners and financial tightening in the United States means that
material restraint to U.S. conditions is already in place. Looking ahead, a further weakening
of foreign growth could pose downside risks to the U.S. outlook. Under normal
circumstances, policy in the United States could adjust to signs that spillovers from
developments abroad were affecting activity in the United States. But with policy rates in the
United States at the lower bound, the ability to offset spillovers from adverse developments
in foreign economies with conventional policy is constrained, suggesting greater caution than
normal.
In conclusion, the Great Recession has sparked innovative actions in a number of countries
that have helped monetary policy escape the constraints of the zero lower bound. Just as it
appears that unconventional monetary policy can provide accommodation domestically
similar to conventional monetary policy, so too it appears that cross-borders spillovers work
through the same channels. Nonetheless, the discontinuity of discrete policy changes around
the zero lower bound can amplify the effects. In response to heightened sensitivity around
these spillovers, countries that have deployed unconventional policy have committed to do
so in a way that targets domestic objectives using domestic instruments, thereby helping to
ensure their actions would support rather than sap global demand.