For release on delivery
3:15 a.m. EDT (9:15 a.m. local time)
May 8, 2018
Monetary Policy Influences on Global Financial Conditions
and International Capital Flows
Panel remarks by
Jerome H. Powell
Chairman
Board of Governors of the Federal Reserve System
at
"Challenges for Monetary Policy and the GFSN in an Evolving Global Economy"
Eighth High-Level Conference on the International Monetary System
sponsored by the International Monetary Fund and Swiss National Bank
Zurich, Switzerland
May 8, 2018
Thank you for inviting me to join you today as part of this distinguished panel.
Our subject is the relationship between "center country" monetary policy and
global financial conditions, and the policy implications of that relationship both for the
center country and for other countries affected. This broad topic has been the subject of a
great deal of research and discussion in recent years. Today I will focus in particular on
the role of U.S. monetary policy in driving global financial conditions and capital flows.
To preview my conclusions, I will argue that, while global factors play an important role
in influencing domestic financial conditions, the role of U.S. monetary policy is often
exaggerated. And while financial globalization does pose some challenges for monetary
policy, efforts to build stronger and more transparent policy frameworks and a more
resilient financial system can reduce the adverse consequences of external shocks.
The well-known Mundell-Fleming "trilemma" states that it is not possible to have
all three of the following things: free capital mobility, a fixed exchange rate, and the
ability to pursue an independent monetary policy. The trilemma does not say that a
flexible exchange rate will always fully insulate domestic economic conditions from
external shocks.1 And, indeed, that is not the case. We have seen that integration of
global capital markets can make for difficult tradeoffs for some economies, whether they
have fixed or floating exchange rate regimes.
Since the Fed is the central bank of the world's largest economy and issuer of the
world's most widely used reserve currency, it is to be expected that the Fed's policy
actions will spill over to other economies. To illustrate this point, the scatterplot on the
left side of figure 1 focuses on movements in interest rates and exchange rates following
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Federal Reserve policy announcements. As you can see, changes in U.S. interest rates
after Fed policy actions (shown on the horizontal axis) lead to corresponding changes in
the value of the dollar (shown on the vertical axis). And because of the dollar's
widespread use around the world, these changes in the dollar affect financial conditions
abroad. Fed policy-related movements in U.S. bond yields also tend to spill over to bond
yields abroad, such as the German yields shown in the scatterplot on the right. Such
spillovers are to be expected in a world of highly integrated financial markets.2 As figure
2 shows, bond yields (left) and equity prices (right) around the world typically move
together fairly closely.
But the influence of U.S. monetary policy on global financial conditions should
not be overstated. The Federal Reserve is not the only central bank whose actions affect
global financial markets. In fact, the United States is the recipient as well as the
originator of monetary policy spillovers. For example, as seen in figure 3, changes in
German yields after European Central Bank policy decisions also pass through to U.S.
yields.3 More broadly, it is notable that although the Fed has raised its target interest rate
six times since December 2015 and has begun to shrink its balance sheet, overall U.S.
domestic financial conditions have gotten looser, in part due to improving global
conditions and central bank policy abroad.
Much of the discussion of the spillovers of U.S. monetary policy focuses on their
effects on financial conditions in emerging market economies (EMEs). Some observers
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have attributed the movements in international capital flowing to EMEs since the Global
Financial Crisis primarily to monetary stimulus by the Fed and other advanced-economy
central banks.4 The data do not seem to me to fit this narrative particularly well. As
illustrated by the blue dashed line in the left panel of figure 4, capital flows to EMEs
were already very strong before the Global Financial Crisis, when the federal funds rate
was comparatively high. The subsequent surge in capital flows in 2009, as the crisis was
abating, largely reflects a rebound from the capital flow interruption during the crisis
itself, though highly accommodative monetary policies in advanced economies doubtless
also played a role. Moreover, capital flows to EMEs started to ease after 2011, a period
when the Federal Reserve continued to add accommodation and reduce yields through
increases in its balance sheet, as shown in the right panel. And, more recently, capital
flows to EMEs have picked up again despite the fact that the Fed has been removing
accommodation since 2015.
If U.S. monetary policy is not the major determinant, what other factors have been
driving EME capital flows? One prominent factor has been growth differentials between
EMEs and advanced economies. In figure 5, the left panel shows that capital inflows to
EMEs picked up post-crisis, in line with the widening of this growth differential, while
the slowdown in inflows after 2011 coincides with its narrowing. Another related
determinant has been commodity prices, as shown in the right panel. The pickup in both
global growth and commodity prices over the past couple of years explains a good part of
the recent recovery of capital flows to EMEs.5
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Monetary stimulus by the Fed and other advanced-economy central banks played
a relatively limited role in the surge of capital flows to EMEs in recent years. There is
good reason to think that the normalization of monetary policies in advanced economies
should continue to prove manageable for EMEs. Fed policy normalization has proceeded
without disruption to financial markets, and market participants' expectations for policy
(the red symbols in figure 6) seem reasonably well aligned with policymakers'
expectations in the Summary of Economic Projections (the black dots), suggesting that
markets should not be surprised by our actions if the economy evolves in line with
expectations.
It also bears emphasizing that the EMEs themselves have made considerable
progress in reducing vulnerabilities since the crisis-prone 1980s and 1990s. Many EMEs
have substantially improved their fiscal and monetary policy frameworks while adopting
more flexible exchange rates, a policy that recent research shows provides better
insulation from external financial shocks.6 Corporate debt at risk--the debt of firms with
limited debt service capacity--has been rising in EMEs, as shown in figure 7.7 But this
rise has been relatively limited outside of China and has begun to reverse as stronger
global growth has pushed up earnings.
Ghosh and others (2012). These papers generally conclude that many factors, including both "pull" and
"push," affect EME capital flows.
6
See, for example, Obstfeld, Ostry, and Qureshi (2017). The results in IMF (2017) also indicate that while
global financial conditions explain a significant portion of countries' domestic financial conditions,
domestic monetary policy changes also play an important role in economies with flexible exchange rates.
7
The interest coverage ratio (ICR) is the ratio of earnings before interest, tax, depreciation, and
amortization to interest expense. A value of 2 or less is typically associated with an increased likelihood of
distress. For example, just before the Asian financial crisis, firms in Korea, Thailand, and Indonesia had an
average ICR of 2; see Pomerleano (1998).
For more on evolution of EME debt at risk and vulnerabilities, see Powell (2017).
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All that said, I do not dismiss the prospective risks emanating from global policy
normalization. Some investors and institutions may not be well positioned for a rise in
interest rates, even one that markets broadly anticipate. And, of course, future economic
conditions may surprise us, as they often do.
Moreover, the linkages among monetary policy, asset prices, and the mood of
global financial markets are not fully understood. Some observers have argued that U.S.
monetary policy also influences capital flows through its effects on global risk sentiment,
with looser policy leading to more positive sentiment in markets and tighter policy
depressing sentiment.8 While those channels may well operate, research at both the Fed
and the IMF suggests that actions by major central banks account for only a relatively
small fraction of global financial volatility and capital flow movements.9
Nevertheless, risk sentiment will bear close watching as normalization proceeds
around the world. What can the Federal Reserve do to foster continued financial stability
and economic growth as normalization proceeds? We will communicate our policy
strategy as clearly and transparently as possible to help align expectations and avoid
market disruptions. And we will continue to help build resilience in the financial system
and support global efforts to do the same.
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References
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Monetary Policy Influences on
Global Financial Conditions and
International Capital Flows
Jerome H. Powell
Chairman
Board of Governors of the Federal Reserve System
Eighth High-Level Conference on the International Monetary System
Sponsored by the International Monetary Fund and Swiss National Bank
May 8, 2018
Figure 1: Changes in U.S. bond yields lead to changes in the value
of the dollar and spill over to German bond yields
Figure 2: Global sovereign bond yields and equity prices
typically move together
Figure 3: Changes in German yields around ECB announcements
pass through to U.S. yields
Figure 4: Capital flows to emerging markets were already strong
before the Federal Reserve cut its policy rate
Figure 5: EME vs. AE growth differentials and commodity prices
drive capital flows to EMEs
Figure 6: Market expectations for Fed policy seem well aligned
with policymaker expectations
Figure 7: Emerging market corporate debt at risk has begun to
reverse its earlier rise, even in China