Alberto G Musalem: US macroeconomic and regulatory developments
and emerging market economies
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 International Financial
Conference Annual Meeting, Cartagena, Colombia, 9 March 2015.
* * *
Thank you for the invitation to speak here today. It has been a pleasure to attend this
conference, and to have the opportunity to exchange views with many of you.
My remarks today will focus on the potential effects of the U.S. outlook and policy for
emerging market economies. I will make three main points.
• The U.S. economy appears likely to make further progress toward the Federal Open
Market Committee's (FOMC) objectives of maximum sustainable employment and
price stability. This actual and prospective improvement underlies market
expectations that the FOMC will begin raising the Federal Funds rate sometime later
this year.
• Emerging market economies (EMEs) have generally performed well during U.S.
tightening cycles, especially when such policy shifts are supported by effective
communication in the context of U.S. growth.
• There has been notable progress in improving the safety and soundness of the
international and U.S. financial systems, to better support financial stability and
economic growth.
Before I turn to the specifics, let me remind you that what I say today reflects my own views,
and not necessarily those of the Federal Reserve Bank of New York or the Federal Reserve
System.
Since the end of the Great Recession almost six years ago, U.S. growth has averaged a
somewhat disappointing 2.3 percent. But growth has picked up recently, and the latest Blue
Chip forecast is for growth to average slightly below 3 percent over the next year.
There are good reasons to think that a period of stronger growth can be sustained.
• Household balance sheets are in much improved condition, with total household
liabilities well below their 2008 peak, and debt service burdens at the lowest share
of disposable income in more than 30 years. Moreover, consumers are benefitting
from the positive wealth effect of higher house and equity prices.
Labor market improvement has picked up pace, with payrolls gains over the last
•
several months the strongest since the mid-1990s. Workers are finally beginning to
see at least modest real wage gains. And the U.S. unemployment rate has fallen to
the lowest level since mid-2008.
• The recent drop in oil prices is providing a significant boost to household spending
power with nearly a percentage point increase to real disposable incomes.
• The housing sector is now in much better balance. The inventory-sales ratio for
homes is near, or even slightly below, levels typically considered "normal," and there
has been a significant drop in the fraction of households carrying mortgage balances
in excess of the value of their homes.
• The fiscal restraint that has held back growth in recent years has given way to a
more neutral posture.
• The non-financial corporate sector remains in generally healthy condition, with high
profit margins and a high ratio of liquid assets to current liabilities.
Of course, there are important risks to the growth outlook including: whether households
behave cautiously relative to fundamentals given the experience of the Great Recession; the
extent of the impact to the oil producing sector from lower oil prices, and the direction of the
business cycle abroad. The FOMC's view in its January statement was that the risks to U.S.
growth are nearly balanced.
There are also risks in both directions to the inflation outlook. Headline inflation has fallen
quite low due to the drop in oil prices. These effects are likely to be transitory. Measures of
underlying inflation such as the core PCE deflator have been running somewhat short of the
FOMC's 2 percent objective for some time. Moreover, market-based measures of
mediumterm inflation compensation have fallen somewhat below the objective in recent months,
even if survey measures of expectations have held essentially steady.
There are also upside risks to inflation. The unemployment rate has declined and wage
growth should firm as remaining slack diminishes. Moreover, the U.S. economy's productivity
performance has been relatively unimpressive in recent quarters. If continued, this could also
begin to push inflation higher.
It is in this context that the Committee has begun to consider the appropriate timing and pace
for removing extraordinary accommodation. The Committee stated in January that "it can be
patient in beginning to normalize the stance of monetary policy," and that the timing of any
policy shift will be data dependent, based on an ongoing careful evaluation of progress
towards the Committee's goals of maximum employment and 2 percent inflation.1
Emerging market officials and market participants have expressed concerns that Fed liftoff
might spark an undue tightening in global financial conditions, creating a new growth
headwind for emerging market economies. These concerns are understandable. The Federal
Funds rate has been near the zero lower bound for more than six years. The Taper Tantrum
in the spring and summer of 2013 provides a ready reminder of the potential for volatility
around actual or perceived news concerning Fed policy.
Like other central banks, the Fed's monetary policy mandate is defined in domestic terms.
Yet the Fed takes the potential international implications of its policies quite seriously. In part,
this comes from a sense of a special responsibility given the international reserve currency
status of the dollar. An outward-looking perspective is also warranted because the
international effects of Fed policies can spill back onto the U.S. economy and financial
conditions.
It is of note that emerging market economic performance during previous Fed tightening
cycles has generally been good. During the last three U.S. tightening cycles, EME industrial
production growth has come to between 71⁄2 and 10 percent over the 12 months from the
start of Fed tightening, while EME export volumes have risen 10 to 15 percent. A likely
explanation for this favorable record is that Fed tightening generally occurs during periods of
strong U.S. economic performance. Recent research from the IMF bears out this hypothesis,
finding that higher U.S. interest rates associated with stronger U.S. growth represent a net
positive for EMEs.2
Financial performance of EMEs has been more diverse across Fed policy cycles. The
strongest contrast is between the tightening cycle that began in 2004, and the one beginning
a decade earlier, in 1994. EME asset prices strengthened considerably during the 2004
cycle, but weakened considerably during the earlier cycle. Notably, the 1994 cycle was
associated with a large increase in U.S. long-term bond yields, and appears to represent a
case in which there was some distance between Fed policy and market expectations. Other
IMF research suggests that anticipated Fed tightening moves have historically been followed
by only a minor pullback in private capital inflows, while unanticipated tightening has typically
been followed by a pullback in private flows some four times as large.3 This evidence
highlights the importance of transparency and clear messaging in how the Fed is evaluating
the evolving economic landscape.
The FOMC has taken a number of steps in recent years to increase transparency and
improve communications. This includes press conferences by the Fed chair following FOMC
meetings; the publishing of growth and inflation forecasts of FOMC participants; participants'
projections of the Federal Funds rate at various horizons; and a concerted attempt to lay out
the guideposts that the FOMC will look at to assess progress toward its mandate. These
steps are aimed at reducing the risk that Fed policy adjustment might be associated with
undue market volatility.
The stance of Fed policy will be far from the only thing affecting the global landscape facing
EMEs. As the FOMC considers the appropriate timing and pace of moving to a less
accommodative policy stance, central banks in the Euro area and Japan are in the process
of implementing additional easing measures. Other important factors affecting the global
terrain include China's slowing of credit growth without derailing economic growth, the
behavior of oil and other commodity prices, and EMEs' own domestic fundamentals and
growth dynamics. Fed policy will be only one factor.
EME fundamentals are likely to be an important determinant of how EME financial conditions
respond to Fed policy normalization. This was one of the key lessons from the Taper
Tantrum. At first, market pressure was somewhat indiscriminant and then later became more
discerning with respect to EME fundamentals. Financial conditions tightened, especially for
countries with fundamental vulnerabilities including: large current account deficits, a heavy
reliance on portfolio inflows, and high and above-target inflation rates. Markets then
responded favorably as EME authorities shifted toward clear, more consistent policies
focused on inflation objectives and external sustainability, and away from policies with
multiple and sometimes competing objectives.
Let me now add a few thoughts about ongoing financial reform efforts. The complexity,
severity and speed of the global financial crisis required a forceful and wide-ranging
international regulatory response. This has included higher capital and liquidity standards,
stronger recovery and resolution regimes for supervised institutions, and greater
transparency and standardization in derivatives markets. These efforts will have a number of
positive effects, although they may lead to some changes in bank business models and
strategy in the U.S. and internationally.
In the U.S., these efforts have made the banking system much stronger today than before
the crisis. In aggregate, Tier 1 risk-based capital ratios among U.S. bank holding companies
have increased to just under 13 percent, an increase of almost 45 percent relative to
precrisis levels, and the quality of capital has improved. Bank holding company balance sheets
are also significantly more liquid, with liquid assets increasing from 26 percent of total assets
at end-2006 to 38 percent at end-2014. Core deposits now fund 44 percent of total assets, a
10 percentage point increase from pre-crisis levels. A stronger U.S. banking system better
protects against future shocks, provides a more solid foundation for growth, and therefore
also enhances prospects for growth and financial stability abroad.
Basel III implementation has been proceeding on a comparable basis in advanced and
emerging market countries. The Financial Stability Board has been monitoring the
unintended effects of reforms on EME banks and EMEs report no significant adverse
effects.4 However, potential differences in reform implementation across jurisdictions could
create challenges, particularly in countries where foreign banks are active. This underscores
the importance of continued home and host coordination.
I would like to briefly touch on two U.S.-specific financial regulatory issues with international
implications, namely enhanced prudential standards for foreign banks, including intermediate
holding company requirements for the largest institutions, and issues surrounding
correspondent banking, U.S. anti-money laundering rules, and "de-risking". Of these, the
latter may have the most relevance for the EMEs broadly.
The adoption of enhanced prudential standards for foreign banking organizations (FBOs) is a
key element of U.S. regulatory reforms, and a significant change in supervision of FBOs.5
The largest FBOs (with U.S. non-branch assets greater than $50 billion) must hold their U.S.
subsidiaries under an intermediate holding company (IHC), and meet various capital,
leverage, liquidity, stress testing, risk management and corporate governance requirements.
These requirements respond to a mandate in the Dodd-Frank Act for enhanced standards for
the largest domestic and foreign banks. The most significant requirements are expected to
fall on the largest FBOs from advanced economies - some of which have also adopted
tighter local requirements for foreign banks - and should contribute importantly to a safer and
sounder U.S. and international financial system.
Correspondent banking relationships have also received heightened attention in the context
of serious violations of anti-money laundering and know-your-customer standards by some
banks, and substantial fines. It is imperative to firmly deal with illegal, unsafe and unsound
banking practices, including money laundering and transactions with U.S.-sanctioned
countries.
It is also important to be on the look-out for potential unintended consequences and
externalities, such as widespread de-risking where correspondent bank access is shut off to
compliant counter parties and to legal flows, economic costs are excessively increased, or
flows migrate to avenues subject to less oversight or transparency. The scope, scale, and
impact of de-risking need to be better understood. Dialogue between market participants and
the official sector is ongoing, both multilaterally and bilaterally.
Let me conclude. The U.S. economy and financial system have strengthened notably in
recent years and in a mutually reinforcing way. U.S. monetary and regulatory policy both
need to be tailored to domestic conditions. The Fed is also mindful of the international effects
of its policies, given the central place of the U.S. in the global financial system, and the
potential for spillbacks to the U.S. economy and financial system. Effective communication
with market participants and policymakers is important. The opportunity for dialogue is what
makes conferences such as this one valuable.
Thank you very much.