Stanley Fischer: Monetary policy in the United States and in developing
countries
Speech by Mr Stanley Fischer, Vice Chair of the Board of Governors of the Federal Reserve
System, at the Crockett Governors' Roundtable 2015 for African Central Bankers, University
of Oxford, Oxford, United Kingdom, 30 June 2015.
* * *
I would like to thank the organizers of the conference for inviting me to this event.1 I have
been invited in the past and had very much wanted to take part - especially in light of my
having been born in Zambia and having received my schooling in Zambia, South Africa, and
Zimbabwe - but somehow it never worked out. I am therefore especially delighted finally to
be here. In my talk today, I will focus on both the challenges facing the Federal Reserve and
those facing central banks of developing countries in our increasingly interconnected world.
But let me begin my remarks with a very brief digression on the history of central banking to
put recent developments in context.
Historical context
Today the great majority of countries have a central bank or an institution that fulfills the
functions of a central bank. But this was not always the case in the past. Even after the
advanced economies began to set up central banks, it was not widely accepted that smaller
nations needed one. Although the first central bank, the Swedish Riksbank, dates back to
1668, it was only in 1920 that the case for setting up a central bank in almost all countries
was recognized among official circles in a resolution of the League of Nations' conference in
Brussels that year, which stipulated, among other things, that "in countries where there is no
central bank of issue, one should be established."2
At the time, the main concern of the participants in the conference was the preservation of
the international monetary order, by which was meant the possibility for both the private and
public sectors of all countries to engage in domestic and international transactions. Since
then, as it has become increasingly apparent that central banks can fulfill many functions, the
number of central banks has expanded from 23 in 1920 to over 160 currently. And not only
are there more central banks, but also the functions of central banks have continued to
evolve.
Until the Great Financial Crisis, both the practice and the theory of modern central banking
revolved around the inflationary tendencies inherent in the conflict between the short- and
long-run effects of monetary expansion and in the temptations of monetary financing of
government spending.3 Taking into account the fact that many leading central banks have
recently had to deal with below-target inflation, one would have to amend the previous
sentence to say that the practice and the theory of modern central banking revolve around
the benefits of keeping monetary policy independent of short-term political considerations -
with respect to both the stabilization of the price level and the temptations of monetary
financing of the budget.
The earliest central banks provided financing for governments and helped develop the
financial system, often by bringing order to the note issue. As the practice of central banking
developed during the 19th century, central banks took on the primary responsibility for
protecting the stability of the financial system and the external value of the currency. The
mandate given to central banks in legislation passed in the 1930s and 1940s typically
included both monetary stability and the promotion of full employment and maximum output -
and frequently other goals as well.
As the inflationary forces that eventually led to the collapse of the Bretton Woods system
gathered strength in the 1960s and 1970s, the focus of monetary policy shifted to the
maintenance of the domestic value of the currency. In the decades that followed, central
banks began to place greater emphasis on the stabilization of inflation, and that trend has
continued to date.4
Although this shift in emphasis originated in the advanced economies, emerging market and
developing economies eventually followed suit, with many of them bringing down high rates
of inflation and formally adopting an inflation targeting policy framework. Even in countries
without formal inflation targeting frameworks, stabilization of inflation remains an important
objective, sometimes alongside other important objectives such as stabilization of the
external value of the currency, stabilization of the macroeconomy, financial stability, and the
development of the monetary and financial systems.
The U.S. economy and monetary policy
In the United States, the Federal Reserve has, since 1977, been operating under a dual
mandate to pursue maximum sustainable employment and price stability.5 Our main
challenge, since the global financial crisis, has been to make rapid (or at least as rapid as
possible) progress toward achieving these objectives. While it has taken a long time, and
extraordinary monetary policy actions, the U.S. economy is now close to full employment,
with core inflation, at 1.2 percent, below our 2 percent inflation target, but, in the view of the
Federal Open Market Committee (FOMC), likely to reach 2 percent within about two years.
Let me provide an update on recent progress toward the attainment of these goals and its
effects on the current stance of the Federal Reserve's monetary policy.
U.S. economic activity and inflation
The U.S. economy slowed sharply in the first quarter of this year, with the most recent
estimate being that real GDP declined 0.2 percent at an annual rate. Household spending
slowed, while both business investment and net exports declined. Much of this slowdown
seemed to reflect transitory factors, including harsh winter weather, labor disputes at West
Coast ports, and probably statistical noise. Confirming that view, the latest monthly data on
real consumption provide welcome evidence that consumer demand is rebounding, and that
economic activity likely expanded at an annual rate of about 2.5 percent in the second
quarter.
In addition, U.S. labor markets have continued to improve. For the first five months of this
year, payroll job gains have averaged 217,000 per month. These gains are lower than those
seen late last year but are still substantial, and they are above the rate needed to maintain
the rate of unemployment at a constant rate of labor force participation. The unemployment
rate has moved lower this year and registered 5.5 percent in May. Both long-term
unemployment and involuntary part-time employment declined as well. While these
developments represents considerable progress toward strengthening of the labor market,
some room remains for further improvement.
There are grounds for optimism that economic growth will be sufficient to promote further
gains in labor market conditions. Consumer spending should be helped by the earlier
declines in oil prices because the boost to household incomes from the drop in oil prices is
substantial. Lower gasoline prices alone are estimated to be saving the typical household
about $700 this year, thus providing households with the resources potentially to increase
spending on other goods and services. Moreover, consumer sentiment remains solid. To be
sure, with the U.S. now a major oil producer, lower oil prices have also had some negative
effects on the U.S. economy. Domestic oil drilling dropped sharply over the past few months,
and sectors that support this activity have seen adverse effects. But, on net, the United
States should gain from the fall in oil prices, given that we are still a sizable importer of oil.
On the negative side, the substantial appreciation of the dollar since last summer has been a
significant headwind to the U.S. economy. The weakness in industrial activity recently has
been more pronounced in sectors that are highly exposed to international trade. The
firstquarter drop in net exports was very large, not only because of the appreciation of the dollar,
but also in part reflecting - as mentioned above - port disruptions and possibly also some
statistical noise. Our analysis of the determinants of U.S. trade suggests that the recent
appreciation of the dollar will restrain economic growth to some extent for a time even after
these transitory factors have dissipated.
Evaluating all of the indicators, the FOMC expects - as outlined in its June 17 statement -
that, with appropriate policy accommodation, economic activity will expand at a moderate
pace, with labor market indicators continuing to move toward levels consistent with the dual
mandate.
Turning to price stability, the other goal of our dual mandate, we have seen little progress
toward inflation moving back to our target of 2 percent. The 12-month change in headline
personal consumption expenditures prices is now close to zero - though that very low level
of inflation is temporary, in large part reflecting the large declines in energy prices around the
turn of 2015. The stronger dollar is also weighing on U.S. inflation by reducing the prices we
pay for our imported goods and services. Core inflation is running at 1-1/4 percent and will
likely remain lower than we would like in the months ahead as the exchange rate effects
pass through. Over the medium term, the FOMC expects inflation to rise gradually toward
2 percent as the labor market tightens and the transitory effects of declines in energy and
import prices wane; indeed, energy prices appear to have stabilized.
U.S. monetary policy
Based on our reading of economic conditions, the FOMC decided at its June 17 meeting to
leave the federal funds rate target range at 0 to 1/4 percent. Importantly, our June statement
included no time-based guidance about the timing of liftoff of the policy rate from zero,
emphasizing, instead, conditions that need to be satisfied before the federal funds rate target
range is adjusted. The Committee will assess progress - both realized and expected -
toward its objectives of maximum employment and 2 percent inflation. Of course, because
monetary policy affects the economy with a lag, we should not wait until we have reached
our objectives to begin adjusting policy. It goes without saying that we are also mindful of the
risks of tightening policy prematurely.
We anticipate that it will be appropriate to raise the target range for the federal funds rate
when we have seen further improvement in the labor market and are reasonably confident
that inflation will move back to 2 percent over the medium term. Thus, our policy will be data
dependent, and the FOMC at upcoming meetings will weigh possible adjustments to the level
of the target federal funds rate, based on its assessment of incoming data and the economic
outlook.
Regarding inflation, an important factor working to increase confidence in the inflation outlook
will be continued improvement in the labor market. Theoretical and empirical evidence
suggests that inflation will eventually begin to rise as resource utilization tightens. And while
the link between wages and inflation can be tenuous, it is encouraging that we are seeing
tentative indications of an acceleration in labor compensation.
Once we begin to remove policy accommodation, the Committee's assessment is that
economic conditions will likely warrant raising the federal funds rate only gradually. Thus, we
expect that the target federal funds rate will remain for some time below levels viewed as
normal in the longer run. But that is only a forecast, and monetary policy will, in practice, be
determined by the data - primarily data on inflation and unemployment.
What about financial stability? We are aware of the possibility that low interest rates
maintained for a prolonged period could prompt an excessive buildup in leverage or cause
underwriting standards to erode as investors take on risks they cannot measure or manage
appropriately in a reach for yield. At this point, the evidence does not indicate that such
vulnerabilities pose a significant threat, but we are carefully monitoring developments in this
area.
U.S. monetary policy spillovers and global interest rates
As we consider the decision of policy rate normalization, we are mindful of possible spillovers
to other economies, including emerging market and developing economies. In an
interconnected world, fulfilling the Federal Reserve's objectives under its dual mandate
requires that we pay close attention to how our own actions affect other countries and how
developments abroad, in turn, spill back into U.S. economic conditions.
In order to minimize the likelihood of surprises and thus avoid creating unnecessary market
and policy volatility, we are striving to communicate our policy strategy clearly and
transparently. Beyond communicating our intentions, we also emphasize that monetary
policy normalization in the United States will occur in the context of a strengthening U.S.
economy, which should benefit the emerging market and developing economies.
Still, one feature of the era after the first increase of the federal funds rate will, in all
likelihood, be higher U.S. and global interest rates compared with their extraordinarily low
levels of recent years. The increase in global interest rates could cause investors to adjust
their portfolios, triggering capital outflows from emerging market and developing economies.
The financing needs of emerging market and developing countries remain substantial. As
tomorrow's session on the outlook for Africa's debt capital markets will discuss, many African
countries were able to issue bonds on the international financial markets in recent years - in
some cases, for the first time in history. This development is due to the significant economic
progress of the continent of the past several years and to commodity booms, ample global
liquidity, and low interest rates.
Higher global interest rates could limit the possibilities for governments to finance their
projects or budgets on the same favorable terms. The reduced ability of governments to
finance their needs will likely increase the challenges faced by central banks in their efforts to
assist the economic growth and development agendas of their national governments.
Emerging market and developing economies have generally done a good job of reducing
their financial and economic vulnerabilities over the past couple of decades. For example,
since the 1990s, many of them have made remarkable progress in reducing inflation,
improving government debt ratios, building foreign reserves, and better regulating and
capitalizing their banking systems. These improved economic fundamentals should bolster
their resilience should normalization of monetary policy in the United States and some other
advanced economies lead to financial market stresses. Even so, policymakers will be better
positioned to cope with shocks, both internal and external, if they continue to strengthen
these economic fundamentals.
Monetary policy in developing countries
As mentioned earlier, the Federal Reserve has operated under a dual mandate of price
stability and maximum employment, which has worked well for the U.S. economy. When it
comes to central banking more generally, I doubt that there is any particular monetary policy
framework that is suitable for all countries for all times. The central bank's choice of
monetary policy framework should depend on the objectives it aims to achieve, on the
challenges that the economy faces, and on the structure of the financial markets and the
economy in which it operates. And it is likely that the monetary policy framework will change
over time as the domestic economy and the international financial system develop.
The exchange rate regime is a key consideration. In recent decades, developing economies
have experienced increasing capital mobility and financial integration into the global
economy. Over the longer term, this is a welcome development that will help meet the
substantial financing needs of the private and public sectors, but greater financial integration
and financial flows also complicate monetary policy in an environment in which exchange
rate considerations are important - and they are generally very important. These are small
open economies in which external shocks are often large, and the excessive volatility
inherent in free-floating exchange rates can be costly. As a consequence, many developing
and emerging market countries both intervene in the foreign exchange markets and impose
restrictions on capital inflows and outflows.
Why not simply peg the exchange rate? According to the impossible triad, or the more
sophisticated version developed by Hélène Rey, the impossible duo, a pegged rate,
combined with capital mobility, makes it difficult for monetary policy to be used independently
to achieve macroeconomic stabilization and price stability.6 Nonetheless, some economies
have successfully implemented pegged exchange rates. Hong Kong and Francophone Africa
are leading examples.
Properly managed, some flexibility of exchange rates can help economies absorb external
shocks, including swings in prices of commodities to which these economies are still heavily
exposed. Accordingly, there has been a shift toward flexible, but managed, exchange rate
systems among emerging market and developing economies. However, none of us should
underestimate the difficulties of managing the exchange rate and of developing knowledge
about when and how much to allow the exchange rate to move in response to domestic and
external economic shocks.
Even beyond the management of the exchange rate, central banks in developing countries
face difficult challenges in developing their monetary policy frameworks. For many years, the
standard International Monetary Fund approach to monetary policy - which embodied the
monetary approach to the balance of payments - emphasized money targets. But this
approach has become less tenable as economies have evolved and matured. As you know,
the effectiveness of such a framework depends, among other things, on the stability of the
money demand function and on the structural relationship between monetary aggregates and
macroeconomic variables. These relationships tend to shift as the financial system develops,
making money targeting frameworks less effective - as we know from the historical
experience of monetary policies in advanced economies.
For this reason, advanced economies abandoned them, and some emerging market
economies followed suit, generally, in favor of inflation targeting frameworks, with short-term
interest rates as the main instruments and the use of open market operations to control the
liquidity in the economy. However the conditions necessary for full-blown inflation targeting
achieved through adjustment of policy interest rates may not be present in some of these
economies.
In the advanced economies and some emerging market economies, financial systems are
relatively well developed, deep, and diversified, which facilitates the conduct of monetary
policy through open market operations. In many of the developing countries, however,
although financial systems are developing rapidly, they remain small and not well diversified,
hindering the ability of central banks to conduct open market operations. Indeed, in many
countries, interbank markets are still underdeveloped, and, even though some central banks
use policy rates, changes to these policy rates have only limited effect on other interest rates
and on the economy more generally. Thus, the ambitions of developing countries to
modernize their monetary policy frameworks have to proceed in parallel with further efforts to
develop the market institutions necessary to conduct monetary policy in a conventional way.7
Concluding remarks
Central banking as a profession has come a long way, striving to adapt itself to the
challenges faced by economies over time, and both the practice and theory of central
banking will continue to evolve. Like others, central banks in developing countries are making
strides in modernizing their policy frameworks and better adapting them to the problems that
their economies face. Nonetheless, significant challenges remain to develop financial
systems and accelerate financial inclusion, to enhance the effectiveness of monetary policy,
and to further expand the institutional and operational capacities of central banks.
I wish you - the governors and high officials of African central banks - well in carrying out
your critical and difficult responsibilities, and I look forward to discussing with you the policy
issues that you confront.
References
Berg, Andrew, Stephen O'Connell, Catherine Pattilllo, Rafael Portillo, Filiz Unsal
(forthcoming). "Monetary Policy Issues in Sub-Saharan Africa," in Célestin Monga and Justin
Yifu Lin, eds., The Oxford Handbook of Africa and Economics: Policies and Practices.
New York: Oxford University Press.
Board of Governors of the Federal Reserve System (2015). "Federal Reserve Issues FOMC
Statement," press release, June 17.
Capie, Forrest, Charles Goodhart, Stanley Fischer, and Norbert Schnadt (1994). The Future
of Central Banking: The Tercentenary Symposium of the Bank of England. Cambridge,
England: Cambridge University Press.
International Monetary Fund (2004). "Monetary Policy Implementation at Different Stages of
Market Development." Washington: IMF, October.
---- (2014). "Conditionality in Evolving Monetary Policy Regimes (PDF)." Washington:
IMF, March.
Laurens, Bernard J., Kelly Eckhold, Darryl King, Nils Maehle, Abdul Naseer, and Alain Durré
(2015). "The Journey to Inflation Targeting: Easier Said than Done-The Case for
Transitional Monetary Arrangements along the Road," IMF Working Paper WP/15/136.
Washington: IMF, June.
League of Nations (1920). Report of the International Financial Conference. Brussels:
League of Nations, October.
Rey, Hélène (2015). "Dilemma not Trilemma: The Global Financial Cycle and Monetary
Policy Independence," NBER Working Paper Series 21162. Cambridge, Mass.: National
Bureau of Economic Research, May.