Lael Brainard: Global financial stability considerations for monetary
policy in a high-inflation environment
Speech by Ms Lael Brainard, Member of the Board of Governors of the Federal
Reserve System, at "Financial Stability Considerations for Monetary Policy", a
research conference organized by the Board of Governors of the Federal Reserve
System and the Federal Reserve Bank of New York, New York City, 30 September
2022.
* * *
I want to start by thanking Anna Kovner, Rochelle Edge, and Bill Bassett for organizing
this conference. The current global environment highlights the importance of having
strong analytic and empirical foundations to understand financial stability considerations
for monetary policy, and the research presented today will help strengthen those
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foundations. The global environment of high inflation and rising interest rates
highlights the importance of paying attention to financial stability considerations for
monetary policy. As monetary policy tightens globally to combat high inflation, it is
important to consider how cross-border spillovers and spillbacks might interact with
financial vulnerabilities.
Inflation is very high in the United States and abroad, and the risk of additional
inflationary shocks cannot be ruled out. In August, CPI (consumer price index) inflation
on a 12-month basis was 8.3 percent in the United States, 9.9 percent in the United
Kingdom, 9.8 percent in Sweden, 9.1 percent in the euro area, 8.7 percent in Mexico,
7.0 percent in Canada, and 5.7 percent in Korea.
Central banks facing high inflation are tightening monetary policy rapidly to damp
demand and bring it into alignment with supply, which is constrained in a variety of
sectors. The process of resolving imbalances will be easier the more supply improves in
markets for commodities, labor, and key intermediate inputs, as is generally expected,
but there is a risk that supply disruptions could be prolonged or aggravated by Russia's
war against Ukraine, COVID-19 lockdowns in China, or weather disruptions. Russia's
war against Ukraine has generated spikes in prices for energy, food, and agricultural
inputs. Most recently, inflation in Europe was pushed higher by Russia's cessation of
natural gas deliveries through the Nord Stream 1 pipeline, creating hardships for
households and risking disruptions for some industries in the affected countries. China's
COVID lockdown policy could also lead to supply disruptions if cases again increase.
Separately, weather conditions in several areas, including China, Europe, and the
United States, are exacerbating price pressures through disruptions to agriculture,
shipping, and utilities.
Many central banks around the world have pivoted monetary policy strongly in order to
maintain anchored expectations and forestall second-round effects from high inflation
becoming embedded in wage and price setting. In the United States, the Federal
Reserve has increased the federal funds rate target range by 300 basis points in the
past seven months-a rapid pace by historical standards-and the Federal Open Market
Committee's most recent Summary of Economic Projections indicates additional
increases through the end of this year and into next year. In addition, beginning this
month, balance sheet shrinkage accelerated to its maximum rate of up to $60 billion in
Treasury securities per month, and up to $35 billion in agency mortgage-backed
securities per month. Broader U.S. financial conditions have tightened rapidly: The
10year Treasury yield has risen more than 200 basis points since the beginning of the
year and is near its highest level in over a decade at 3.8 percent.
At a global level, monetary policy tightening is also proceeding at a rapid pace by
historical standards. Including the Federal Reserve, nine central banks in advanced
economies accounting for half of global GDP have raised rates by 125 basis points or
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more in the past six months. Global financial conditions have likewise tightened.
Yields on 10-year sovereign debt in the United States, Canada, the United Kingdom,
and the largest euro area economies are higher year to date between 170 and 350
basis points.
It will take some time for the global tightening to have its full effect in many sectors.
While the effect on financial conditions tends to be immediate or even anticipatory, the
effects on activity and price setting in different sectors may occur with a lag, with highly
interest-sensitive sectors such as housing adjusting quickly and less rate-sensitive
sectors such as consumer spending on services adjusting more slowly.
In addition to the domestic effects from domestic tightening, there are cross-border
effects of tightening through both trade and financial channels. U.S. monetary policy
tightening reduces U.S. demand for foreign products, thus amplifying the effects of
monetary tightening by foreign central banks. The same is true in reverse: Tightening in
large jurisdictions abroad amplifies U.S. tightening by damping foreign demand for U.S.
products.
Tightening in financial conditions similarly spills over to financial conditions elsewhere,
which amplifies the tightening effects. These spillovers across jurisdictions are present
for decreases in the size of the central bank balance sheet as well as for increases in
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the policy rate. Some estimates suggest that the spillovers of monetary policy
surprises between more tightly linked advanced economies such as the United States
and Europe could be about half the size of the own-country effect when measured in
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terms of relative changes in local currency bond yields.
In contrast, spillovers through exchange rate channels tend to go in opposite directions.
The Federal Reserve's broad nominal U.S. dollar index has appreciated over 10
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percent year to date. On balance, dollar appreciation tends to reduce import prices in
the United States. But in some other jurisdictions, the corresponding currency
depreciation may contribute to inflationary pressures and require additional tightening to
offset.
We are attentive to financial vulnerabilities that could be exacerbated by the advent of
additional adverse shocks. For instance, in countries where sovereign or corporate debt
levels are high, higher interest rates could increase debt-servicing burdens and
concerns about debt sustainability, which could be exacerbated by currency
depreciation. An increase in risk premiums could kick off deleveraging dynamics as
financial intermediaries de-risk. And shallow liquidity in some markets could become an
amplification channel in the event of further adverse shocks.
For some emerging economies, high interest rates in combination with weaker demand
in advanced economies could increase capital outflow pressures, particularly
commodity importers facing higher commodity prices and weaker exchange rates. And
these pressures would be particularly challenging for borrowers with currency
mismatches between their assets and liabilities.
This is especially true at times when fiscal, macroprudential, and monetary buffers are
more limited. Fiscal and monetary policy were both supportive in response to the
pandemic, and both were naturally expected to reverse course as the recovery
gathered steam. But the advent of the war has led to a significant hit to real incomes
from large price increases in energy and other commodities in some of the most
severely affected economies.
With respect to macroprudential buffers, nearly all of the jurisdictions that built
countercyclical capital buffers before the pandemic released those buffers at the outset
of the pandemic, and the buffers have not been fully replenished so far. A European
Central Bank analysis concluded that the release of capital buffers increased headroom
for banks relative to not only their regulatory thresholds, but also their internal risk
controls, and enabled banks to continue providing credit to households and businesses.
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And of course, monetary policy is focused on restoring price stability in a high-inflation
environment. As the program's first research paper illustrates, in circumstances in
which macroprudential policy cannot on its own eliminate the amplification of shocks
through financial vulnerabilities, in a low-inflation environment, monetary policy has
been relatively more accommodative than would be prescribed by a conventional
monetary policy rule in order to reduce the likelihood of adverse output and employment
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outcomes. But in a high-inflation environment, monetary policy is restrictive to restore
price stability and maintain anchored inflation expectations.
The Federal Reserve's policy deliberations are informed by analysis of how U.S.
developments may affect the global financial system and how foreign developments in
turn affect the U.S. economic outlook and risks to the financial system. We engage in
frequent and transparent communications with monetary policy officials from other
countries about the evolution of the outlook in each economy and the implications for
policy. We meet regularly not only with monetary policy officials from different countries,
but also with fiscal and financial stability officials in a variety of international settings,
which helps us to take into account cross-border spillovers and financial vulnerabilities
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in our respective forecasts, risk scenarios, and policy deliberations.
High inflation imposes significant hardships by eroding purchasing power, especially for
those households that spend the greatest share of their incomes on essentials like food,
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housing, and transportation. Following a period where a combination of high demand
and a lengthy sequence of adverse supply shocks to goods, labor, and commodities
drove inflation to multidecade highs, monetary policymakers are taking a
riskmanagement posture to guard against risks of longer-term inflation expectations moving
above target, which would make it more difficult to bring inflation down.
In the modal outlook, monetary policy tightening to temper demand, in combination with
improvements in supply, is expected to reduce demand-supply imbalances and reduce
inflation over time. The real yield curve is now in solidly positive territory at all but the
very shortest maturities, and with the additional tightening and deceleration in inflation
that is expected over coming quarters, the entire real curve will soon move into positive
territory.
It will take time for the full effect of tighter financial conditions to work through different
sectors and to bring inflation down. Monetary policy will need to be restrictive for some
time to have confidence that inflation is moving back to target. For these reasons, we
are committed to avoiding pulling back prematurely. We also recognize that risks may
become more two sided at some point. Uncertainty is currently high, and there are a
range of estimates around the appropriate destination of the target range for the cycle.
Proceeding deliberately and in a data-dependent manner will enable us to learn how
economic activity and inflation are adjusting to the cumulative tightening and to update
our assessments of the level of the policy rate that will need to be maintained for some
time to bring inflation back to 2 percent.
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I want to thank Kurt Lewis and Shaghil Ahmed of the Federal Reserve Board for their
assistance on these remarks. These views are my own and do not necessarily reflect
those of the Federal Reserve Board or the Federal Open Market Committee.
2
The central banks of the United States, the United Kingdom, Canada, the euro area,
Australia, New Zealand, Norway, Sweden, and Switzerland together account for 49
percent of nominal global GDP measured in dollars at market exchange rates. Each of
these central banks has raised its policy rate by at least 125 basis points in the past six
months.
3
See Lael Brainard (2015), "Unconventional Monetary Policy and Cross-Border
Spillovers ," speech delivered at "Unconventional Monetary and Exchange Rate
Policies," 16th International Monetary Fund Jacques Polak Research Conference,
Washington, November 6; and Lael Brainard (2017), "Cross-Border Spillovers of
Balance Sheet Normalization," speech delivered at the National Bureau of Economic
Research's Monetary Economics Summer Institute, Cambridge, Mass., July 13.
4
A paper based on data between 2005 and 2017 found that about half of the reaction
in German domestic yields spills over to U.S. yields following ECB announcements,
which was nearly identical to the spillover from U.S. yields to German bund yields
measured following Federal Open Market Committee announcements. See Stephanie
E. Curcuru, Michiel De Pooter, and George Eckerd (2018), "Measuring Monetary Policy
Spillovers between U.S. and German Bond Yields," International Finance Discussion
Papers 1226 (Washington: Board of Governors of the Federal Reserve System, April).
5
The Federal Reserve's broad trade-weighted dollar index is based on 26 currencies of
major U.S. trading partners. It is published in Statistical Release H.10, "Foreign
Exchange Rates," available on the Board's website at https://www.federalreserve.gov
/releases/h10/current/default.htm .
6
These findings were part of a box in the ECB's May 2022 Financial Stability Review
titled " Transmission and Effectiveness of Capital-Based Macroprudential Policies." See
Financial Stability Review
European Central Bank (2022), (Frankfurt: ECB, May), pp.
93-95. The countercyclical buffer has not been activated in the United States.
7
See Tobias Adrian and Fernando Duarte (2016), "Financial Vulnerability and
Monetary Policy (PDF)," Staff Reports 804 (New York: Federal Reserve Bank of New
York, December; revised November 2020).
8
See Richard H. Clarida (2021), "Perspectives on Global Monetary Policy
Coordination, Cooperation, and Correlation," speech delivered at the "Macroeconomic
Policy and Global Economic Recovery" 2021 Asia Economic Policy Conference,
sponsored by the Federal Reserve Bank of San Francisco Center for Pacific Basin
Studies, San Francisco (via webcast), November 19.
9
See Lael Brainard (2022), " Variation in the Inflation Experiences of Households ,"
speech delivered at the Spring 2022 Institute Research Conference, Opportunity and
Inclusive Growth Institute, Federal Reserve Bank of Minneapolis, Minneapolis (via
webcast), April 5.
10
See, for example, the year-to-date improvement in the Federal Reserve Bank of New
York's Global Supply Chain Pressure Index, available on the Bank's website at
https://www.newyorkfed.org/research/policy/gscpi#/interactive .