Stanley Fischer: The Federal Reserve and the global economy
Speech by Mr Stanley Fischer, Vice Chair of the Board of Governors of the Federal Reserve
System, at the conference held in honor of Professor Haim Ben-Shahar, former President of
Tel Aviv University, Tel Aviv University, Tel Aviv, Israel, 26 May 2015.
* * *
I am grateful to John Ammer, Christopher Erceg, Joseph Gruber, and Beth Anne Wilson of the Federal Reserve
Board's staff for their assistance in preparing these remarks.
I am happy to be here today, and I thank the organizers for inviting me. It is a particular
pleasure to be back in Israel, where my career as a central banker began. At the Fed, I face
a somewhat different set of responsibilities, and my lecture today is on the special challenges
that face the Federal Reserve and the global economy in an increasingly interconnected
world.1
Over the past 50 years, global trade has more than tripled relative to world gross domestic
product (GDP), and the ratio of total exports to global GDP now stands at about 30 percent -
though, interestingly, the rate of growth of global international trade has declined to the level
of the growth rate of world GDP since the start of the Great Recession. International trade
has not loomed as large in the U.S. national accounts as it has for many other countries, but
it is an increasingly important driver of the U.S. economy, with the share of trade in U.S. GDP
currently at about 15 percent.
Although the U.S. share of world GDP has gradually declined since the mid-20th century, the
broader importance of the United States to the global economy has diminished less, as a
result of increasing financial linkages. In particular, U.S. residents' ownership of private
foreign assets has risen from 6.5 percent of U.S. annual GDP in 1950 to more than
140 percent of annual U.S. GDP (nearly $25 trillion), reflecting the leading role of U.S. capital
markets in cross-border finance. Total foreign investment in the United States is even larger,
at more than $30 trillion.
In a progressively integrating world economy and financial system, a central bank cannot
ignore developments beyond its country's borders, and the Fed is no exception. This is true
even though the Fed's statutory objectives are defined as specific goals for the U.S.
economy. In particular, the Federal Reserve's objectives are given by its dual mandate to
pursue maximum sustainable employment and price stability, and our policy decisions are
targeted to achieve these dual objectives.2 Hence, at first blush, it may seem that there is
little need for Fed policymakers to pay attention to developments outside the United States.
But such an inference would be incorrect. The state of the U.S. economy is significantly
affected by the state of the world economy. A wide range of foreign shocks affect U.S.
domestic spending, production, prices, and financial conditions. To anticipate how these
shocks affect the U.S. economy, the Federal Reserve devotes significant resources to
monitoring developments in foreign economies, including emerging market economies
(EMEs), which account for an increasingly important share of global growth. The most recent
available data show 47 percent of total U.S. exports going to EME destinations. And of
course, actions taken by the Federal Reserve influence economic conditions abroad.3
Because these international effects in turn spill back on the evolution of the U.S. economy,
we cannot make sensible monetary policy choices without taking them into account.
In this lecture, I would like to emphasize both aspects of our global connectedness -
spillovers from the United States to foreign economies and the effect of foreign economies
on the United States.
I. International transmission of monetary policies
The recognition that a change in interest rates in one nation can spill over to other countries
dates back at least to the 18th-century writings of David Hume on the international effect of
changes in the money supply.4 The standard models incorporating the international
transmission of monetary policy were developed by Marcus Fleming and Robert Mundell. In
the Mundell-Fleming framework, as well as in modern developments of the same theme, a
shift toward a more accommodative monetary policy in the United States spills over to
foreign economies by causing their interest rates to fall - though typically by less than in the
United States - and their currencies to appreciate against the dollar. At the same time,
international capital flows tend to shift toward foreign economies in response to their
relatively more attractive interest rates.
The pass-through of changes in U.S. policy rates abroad depends importantly on how foreign
monetary authorities respond. A decline in U.S. policy rates has a relatively large effect on
foreign policy rates in economies that opt to limit exchange rate fluctuations, at least for
economies with reasonably open capital accounts. By contrast, a central bank in an economy
with a freely floating exchange rate might choose to lower its interest rate by a much smaller
amount than in the United States if it believes that domestic conditions so warrant. In this
case, the country's exchange rate would appreciate as investors rebalance their portfolios in
favor of assets denominated in its currency in response to the higher interest rate
differential.5
There is also evidence that monetary policy actions can influence investors' willingness to
hold risky assets, the so-called risk-taking channel.6 Such effects seem to be most potent
when financial conditions are stressed. And countries that offer high prospective returns but
have weak policy frameworks or other structural vulnerabilities may be particularly sensitive
to fluctuations in international investment associated with global risk factors.7
3
For a discussion of the effect of Federal Reserve actions on international economic conditions, see Rey
(2015).
4
See Hume (1742).
5
See Mundell (1963) and Fleming (1962). One key implication of the Mundell-Fleming framework is that a
central bank can exercise full control over both the exchange rate and the domestic interest rate only when
there are significant barriers to the international capital mobility. Accordingly, policymakers face the constraint
of the "impossible trinity," which states that a country cannot simultaneously have an independent monetary
policy, free capital movement, and a fixed exchange rate.
6
Several recent papers discuss risk-taking channels through which monetary policy influences financial
conditions more broadly than the level of safe interest rates. See Borio and Zhu (2012), Rey (2015), Morris
and Shin (2014), Bruno and Shin (2015), and the Hanson and Stein (2015) "reaching for yield" concept.
7
Studies using panel data typically have found that country-specific factors help explain cross-sectional
differences in international investment and capital flows. See, for example, Furceri, Guichard, and Rusticelli
(2011); Fratzscher (2012); and Luca and Spatafora (2012). Avdjiev and Takáts's (2014) study of cross-border
bank lending during the "taper tantrum" shows a larger pullback for countries with weaker current account
balances, and Sahay and others (2014) find that country-specific market reactions during this period also were
affected by high inflation, weak growth prospects, and relatively low reserves.
Effects of monetary accommodation since the global financial crisis
After the 2007-08 global financial crisis, there has been heightened concern about the
international spillovers of monetary policies - and of ours, in particular. Some EME critics
argued that U.S. policy accommodation contributed to a surge of capital inflows and
excessive credit growth in their economies, creating risks of financial instability. But, as time
wore on, most EMEs seemed glad to receive those flows.
There is little doubt that the aggressive actions the Federal Reserve took to mitigate the
effects of the global financial crisis significantly affected asset prices at home and abroad as
well as international capital flows. While the Fed's asset purchases were composed wholly of
Treasury, agency, and agency-backed securities (for legal and practical reasons), the
program also aimed to boost the prices of riskier assets and ease financial conditions for the
private sector.8 (And this is what the textbooks say the program should have done.) The
preponderance of evidence suggests that the Fed's asset purchases raised the prices of the
assets purchased and close substitutes as well as those of riskier assets.9
Importantly, evidence shows that foreign asset markets have been significantly affected by
the Fed's purchase programs.10 For example, event studies of announcements associated
with the Fed's purchase programs have found that they prompted inflows into investment
funds holding both foreign debt and foreign equity securities.
Of course, other countries' monetary policy announcements can also leave an imprint on
international asset prices, with market reactions to new initiatives enacted by the European
Central Bank (ECB) one recent example.11 However, event studies tend to find larger
international interest rate spillovers for U.S. policy announcements than for those of other
central banks.12
Earlier studies of the international effects of conventional U.S. monetary policy - namely,
changes in the policy rate - have also found significant spillovers to asset prices in other
countries.13 Studies that have compared the spillovers of monetary policy across
conventional and unconventional measures generally conclude that the effects on global
financial markets are roughly similar.14
Given the relatively fast recovery of many EMEs from the crisis, post-crisis monetary
accommodation in the United States and other advanced economies created policy
8
See, for example, Bernanke (2010a, 2010b).
9
See, for example, D'Amico and King (2013); Gagnon, Raskin, Remache, and Sack (2011); Hamilton and Wu
(2012); and Rogers, Scotti, and Wright (2014).
10
See Neely (2011); Fratzscher, Lo Duca, and Straub (2013); Rogers, Scotti, and Wright (2014); and Bowman,
Londono, and Sapriza (2014). Also, Ahmed and Zlate (2014) show that both conventional and
nonconventional U.S. monetary expansion have driven capital flows into EMEs.
11
See Rogers, Scotti, and Wright (2014) and Chen, Filardo, He, and Zhu (2012) for more systematic evidence.
12
See, for example, Rogers, Scotti, and Wright's (2014) recent event study of central bank announcement
effects on sovereign yields in different countries. Similarly, earlier work by Ehrmann and Fratzscher (2005)
finds larger reactions in euro-area interest rates to U.S. rate changes than vice versa.
13
See, for example, Ehrmann and Fratzscher (2009) and Hausman and Wongswan (2011).
14
Among studies of spillovers from conventional versus unconventional U.S. monetary policy, Rogers, Scotti,
and Wright (2014) report no significant differences in relative announcement effects on advanced foreign
economy asset prices and Treasury yields; Bowman, Londono, and Sapriza (2014) find similar EME asset
price responses; Takáts and Vela (2014) report mixed results for EMEs, with a weaker post-2007 relationship
in levels of EME policy rates with U.S. rates but a stronger post-2008 relationship in levels of five-year yields;
and Glick and Leduc (2013) also report similar spillovers to exchange rates. The effects of the Bank of
England's quantitative easing program on corporate bond yields and sterling exchange rates are similar to
predictions from a model estimated over an earlier period by Joyce, Lasaosa, Stevens, and Tong (2011).
challenges for many EMEs.15 If they resisted currency appreciation pressures by lowering
their policy rates, they risked overstimulating domestic demand, exacerbating financial
excesses, and overheating their economies. If, instead, they reduced their policy rates less
than the United States had done while intervening to resist currency appreciation, capital
inflows could have increased further, thus partially offsetting their attempts to stabilize their
economies. And, if they allowed currency appreciation pressures to pass through to their full
extent, this could threaten their recoveries by hurting exports. In the event, EMEs tried to
make the best of a difficult set of tradeoffs by allowing some exchange rate appreciation,
partially reducing their interest rates, and in some countries also using capital controls.
I would also argue strongly that U.S. monetary policies were not beggar thy neighbor policies
in that, on balance, they generally did not drain demand from other economies. Federal
Reserve staff analysis finds that an easing of monetary policy in the United States benefits
foreign economies from both stronger U.S. activity and improved global financial conditions.
The "taper tantrum" of 2013
We should also expect spillovers when monetary policy is tightened. Central bank
communications can be a tricky business. And indeed, financial markets reacted strongly to
the first statements by Chairman Bernanke in the spring of 2013 that the Fed's asset
purchases were likely to decelerate in the near future and come to an end not long after that.
Some market participants clearly understood these statements to be broadly in line with
previous guidance about the eventual normalization of policy as recovery of the U.S.
economy took hold. But others may have grown accustomed to continuing asset purchases;
the most recent program of quantitative easing, commonly referred to as QE3, had been first
announced less than a year before and was proceeding at a steady pace of $85 billion per
month.
The onset of the taper tantrum went well beyond a roiling of U.S. financial markets. Spillovers
to other advanced-economy financial markets included stock price declines, significant
increases in sovereign yields, higher overnight interest swap rates in the United Kingdom
and euro area, and rising credit spreads in some countries. Spillovers to EME asset markets
were significantly stronger. Inflows to EME investment funds reversed sharply, EME
currencies depreciated, and other asset prices declined.16
II. Normalization of monetary policies
The cumulative effects over half of a decade of the extraordinary actions by the Federal
Reserve and other central banks will need to be unwound in the coming years as the U.S.
and other economies make progress toward economic recovery. In the normalizing of its
policy, just as when loosening policy, the Federal Reserve will take account of how its
actions affect the global economy.
The taper tantrum episode notwithstanding, most EMEs have generally weathered the
winddown of our asset purchases reasonably well so far. The actual raising of policy rates could
trigger further bouts of volatility, but my best estimate is that the normalization of our policy
should prove manageable for the EMEs. We have done everything we can, within the limits
of forecast uncertainty, to prepare market participants for what lies ahead.
The Federal Reserve and other central banks are going to great lengths to communicate
policy intentions and strategies clearly. Given this, markets should not be greatly surprised
by either the timing or the pace of normalization. In fact, it bears mentioning that, following
the taper tantrum, when the Fed started to taper its purchases, there was little reaction from
markets.
The tightening of U.S. policy will begin only when the U.S. expansion has advanced far
enough - when we have seen further improvement in the labor market and when we are
reasonably confident that the inflation rate will rise to our 2 percent goal.17 The stronger U.S.
economy should directly benefit our foreign trading partners by raising the demand for their
exports, and perhaps also indirectly, by boosting confidence globally. And if foreign growth is
weaker than anticipated, the consequences for the U.S. economy could lead the Fed to
remove accommodation more slowly than otherwise.
The EMEs themselves have generally done a good job of reducing their financial and
economic vulnerabilities over the past couple of decades, which should bolster their
resilience should normalization lead to financial market stresses. Since the 1990s, many
EMEs have made remarkable progress in reducing inflation, improving government debt
ratios, building foreign reserves, and better regulating and capitalizing their banking systems.
In addition, the development of local-currency debt markets has made EMEs less vulnerable
to exchange rate fluctuations. To be sure, some EMEs continue to face a wide array of
structural and policy challenges, including, prominently, rapid credit growth. But it does not
seem that the overall risks to global financial stability are unusually elevated at this time.
Nevertheless, it could be that some more vulnerable economies, including those that pursue
overly rigid exchange rate policies, may find the road to normalization somewhat bumpier.
This gives all the more reason for the Fed and other major central banks to communicate
policy intentions clearly and for EMEs to continue to strengthen their policy frameworks and
to consider their own policy responses to the forthcoming normalization in the United States
and some other advanced economies.
III. The Fed's responsibility to the global economy
So far, I have focused on the immediate spillovers of U.S. monetary policy abroad and the
feedback of those effects to the U.S. economy. More tacitly than explicitly stated has been
my view that the United States is not just any economy and, thus, the Federal Reserve not
just any central bank. The U.S. economy represents nearly one-fourth of the global economy
measured at market rates and a similar share of gross capital flows. The significant size and
international linkages of the U.S. economy mean that economic and financial developments
in the United States have global spillovers. It is, therefore, important to ask, what is the
Federal Reserve's responsibility to the global economy?
First and foremost, it is to keep our own house in order. Economic and financial volatility in
any country can have negative consequences for the world, but sizable and significant
spillovers are almost assured from an economy that is large. There is no question that sharp
declines in U.S. output or large deviations of U.S. inflation from its target level would have
adverse effects on the global economy. Conversely, strong and stable U.S. growth in the
context of inflation close to our policy objective has substantial benefits for the world. Thus,
as part of our efforts to achieve our congressionally mandated objective of maximum
sustainable employment and price stability, the Federal Reserve will also seek to minimize
adverse spillovers and maximize the beneficial effect of the U.S. economy on the global
economy.
As the recent financial crisis showed all too clearly, to achieve this objective, we must take
financial stability into account. For half a decade, we have been working to understand and
better guard against the financial disruptions that were the genesis of the Great Recession.
These efforts have spawned many speeches, including some of my own, which testify to our
efforts.18 In these speeches, we often emphasize that, given the integration of global capital
markets, what happens in one market affects others. Thus, our efforts to stabilize the U.S.
financial system also have positive spillovers abroad.
These financial stability responsibilities do not stop at our borders, given the size and
openness of our capital markets and the unique position of the U.S. dollar as the world's
leading currency for financial transactions. For example, the global financial crisis highlighted
the extent of borrowing and lending in U.S. dollars by foreign financial institutions. When
these institutions came under pressure, their actions contributed to the strains in both foreign
and domestic dollar funding markets. To achieve financial stability domestically and maintain
the flow of credit to American households and businesses, we took action. Importantly, we
developed swap facilities with central banks in countries that represented major financial
markets or trading centers in order to facilitate the provision of dollar liquidity to these
markets.
We did so in recognition of the scope of dollar markets and dollar-denominated transactions
outside of our country, the benefits they provide to U.S. households and firms, and the
adverse consequences to our financial markets if these centers lose access to dollar liquidity.
We have continued to maintain swap facilities with a number of central banks. Although
usage is currently very low, these facilities represent an important backstop in the event of a
resurgence in global financial tensions.
But I should caution that the responsibility of the Fed is not unbounded. My teacher Charles
Kindleberger argued that stability of the international financial system could best be
supported by the leadership of a financial hegemon or a global central bank.19 But I should be
clear that the U.S. Federal Reserve System is not that bank. Our mandate, like that of
virtually all central banks, focuses on domestic objectives. As I have described, to meet
those domestic objectives, we must recognize the effect of our actions abroad, and, by
meeting those domestic objectives, we best minimize the negative spillovers we have to the
global economy. And because the dollar features so prominently in international transactions,
we must be mindful that our markets extend beyond our borders and take precautions, as we
have done before, to provide liquidity when necessary.
That said, the world is not without other resources to guard against adverse economic and
financial spillovers. Most obviously, the International Monetary Fund has played and will
continue to play a critical role in providing liquidity and financial support to its member
countries. In the United States, we are working to ensure that our financial institutions and
other market participants are prepared for the normalization of monetary policy and the
return to a world of higher interest rates. It is equally important that individuals, businesses,
and institutions around the world do the same. For our part, the Federal Reserve will promote
a smooth transition by communicating our assessment of the economy and our policy
intentions as clearly as possible.
IV. Concluding remarks
To summarize and conclude, the Fed's statutory objectives are defined by its dual mandate
to pursue maximum sustainable employment and price stability in the U.S. economy. But the
U.S. economy and the economies of the rest of the world have important feedback effects on
each other. To make coherent policy choices, we have to take these feedback effects into
account. The most important contribution that U.S. policymakers can make to the health of
the world economy is to keep our own house in order - and the same goes for all countries.
Because the dollar is the primary international currency, we have, in the past, had to take
action - particularly in times of global economic crisis - to maintain order in international
capital markets, such as the central bank liquidity swap lines extended during the global
financial crisis. In that case, we were acting in accordance with our dual mandate, in the
interest of the U.S. economy, by taking actions that also benefit the world economy. Going
forward, we will continue to be guided by those same principles.
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