Category Archives: Monetary Policy

The Global Impact of the Fed’s Pivot on Asset Purchases

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Federal Reserve Chair Jerome Powell announced last month that the Fed would slow its purchases of bonds, most likely by the end of this year. The timing of the cutback will depend on several factors related to the economy, and last week’s disappointing employment report if repeated could push back the date. The financial markets will now begin anticipating the impact of the reduction in the Fed’s asset holdings.

The origins of the increase in the Fed’s holdings of Treasury bonds and mortgage-backed securites can be traced back to the global financial crisis. The Fed’s assets grew from $870 billion in August 2007 to $2 trillion in early 2009. When the Fed introduced its quantitative easing program, it claimed that the purchases of bonds would lead to lower long-term interest rates more quickly than if it relied only on lowering the Federal Funds rate. In addition, the purchases showed the Fed’s commitment to keeping interest rates low in order to boost the economic recovery. This latter form of signaling was called “forward guidance.”

Subsequent quantitative easing programs eventually raised its holdings to $4.5 trillion by 2015. The Fed maintained that level until 2018, when it allowed its holdings to fall as bonds matured. But it reversed course in 2019, and the Fed responded to the pandemic in the spring of 2020 by ramping up its purchases of assets in order to support the financial markets. Its asset holdings now total about $8.3 trillion.

The Fed has not been alone in using asset purchases as a tool of policy. The European Central Bank increased its holdings of bonds during the period preceding the pandemic from 2 trillion Euros at the end of 2014 to 4.6 trillion Euros. It accelerated its purchases last year and now holds about 8.2 trillion Euros in assets. The Bank of Japan and the Bank of England have their own versions of asset purchase programs. Many of these central banks have also announced changes in the pace of their asset purchases.

When then Fed chair Ben Bernanke noted in 2013 that continued strengthening of the economy could lead to a cutback in asset purchases, this was interpreted as a sign that the Fed would also allow interest rates to rise. This led to the infamous “taper tantrum,” as financial markets overreacted to the prospects of higher interest rates. The response included capital outflows from emerging market countries such as India as their exchange rates depreciated and their own asset markets fell in value. Stability was eventually reestablished once the Fed clarified that it had no plans to enact a contractionary policy, but the incident demonstrated the volatility of financial markets, particularly in the emerging market countries.

Powell has sought to avoid such an outcome by explicitly delinking asset purchases from interest rates. He pledged to keep the Federal Funds rate at its current setting until “maximum employment and sustained 2% inflation” area achieved. The (lack of a)  response in the financial markets to Powell’s speech seemed to indicate that this promise was seen as credible, despite concerns about inflation.

But there will be consequences when the Fed cuts back on its asset purchases. The increases in the Fed’s balance sheet, as well as those of the other central banks, released a wave of liquidity with wide-ranging consequences. In the U.S. it has kept stock price valuations at elevated levels, which contributes to widening wealth inequality. For example, in 2019 families in the top 10% of the income distribution owned 70% of total stock values. Similarly, the provision of easy credit has contributed to rising housing prices that also reflects demand and supply conditions.

The increase in liquidity also benefited emerging markets and developing economies. In the period immediately before the pandemic the World Bank warned that the world had experienced a rise in debt, both private and government. Total debt in the emerging markets and developing economies had risen from 114% of their GDP in 2010 to 170% at the end of 2018. Part of this increase reflected accommodative monetary policies in the advanced economies and a search for higher yield by investors in those countries. A rising global demand for the bonds of the emerging market and developing economies countries was met by an increase in their issuance.

These countries suffered massive reversals of foreign capital in the spring of 2020. The “sudden stops” confirmed the existence of a global financial cycle that can overwhelm vulnerable economies. But the withdrawals were soon reversed, in part because investors were reassured by the rapid responses of central banks in the advanced economies to the financial meltdown.

There are many who voice concerns about the ending of the current financial cycle. Mohammed El-Erian, president of Queens’ College of Cambridge University, is worried about the excessive risk-taking that the financial sector has undertaken in response to its “unhealthy codependency” with central banks.  Raghuram Rajan of the University of Chicago’s Booth School of Business is alarmed about the impact that future interest rate hikes could have on government finances. Jeremy Grantham of asset management firm GMO believes that the stock market will experience a massive crash. And IMF Managing Director Kristalina Georgieva is concerned about a diveregence in the prospects of advanced economies and a few emerging markets versus those of most developing economies that could lead to a debt crisis.

Much of the impact of the policy changes at the Federal Reserve depends on how the financial markets respond to the slowdown in purchases, and whether the Fed is successful in delinking a cutback in asset purchases from its interest rate policy. The lack of a strong response in the bond markets suggests that there has not been a change in expectations of future interest rates. But ouside the U.S. there is always the prospect that a slowdown in economic growth and the continuation of the pandemic imperil the solvency of corporate and government borrowers. These developments would be enough to fuel a debt crisis despite the Fed’s careful footwork.

The Long Reach of U.S. Monetary Policy

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The spillover of U.S. monetary policy on foreign economies has become an active area of research. Analysts seek to identify the channels of transmission between the policy stance of the Federal Reserve and foreign interest rates and credit extension. The usual account is that an expansionary Fed policy leads to capital outflows and an appreciation of foreign currencies as investors seek higher yields abroad. Two recent papers have focused on different aspects of this linkage.

Silvia Albrizio of the Bank of Spain, Sangyup Choi of Yonsei University, Davide Furceri of the IMF and Chansik Yoon of Princeton University investigated the impact of monetary tightening on cross-border bank lending in an IMF working paper, “International Bank Lending Channel of Monetary Policy.” Previous work was divided on whether a contractionary U.S. policy would lead to a decline or an increase in international bank lending. These economists used data on exogenous policy shocks in the U.S., which are based on the narrative approach of  Romer and Romer (2004), to examine their impact on cross-border bank lending in 45 countries.

The results show clear signs of a significant negative effect of U.S. monetary policy shocks on cross-border lending. A 100 basis point rise in the policy rate leads to a sizable more than 10% fall in lending after two quarters. When the authors extended their analysis to include monetary policy shocks in Canada, Germany, Italy, Japan, the Netherlands, Spain, Sweden and the U.K., they again found that exogenous monetary tightening in these economies led to a decline in cross-border bank lending. These results hold even when the authors control for global uncertainty or liquidity risks.

Sebnem Kalemli-Özcan of the University of Maryland focused on the impact of U.S. monetary policy changes on risk in her 2019 Jackson Hole presentation, “U.S. Monetary Policy and International Risk Spillovers.” In her analysis, there are two components of risk, global risk and country-specific risk, and these are crucial elements in the transmission of changes in U.S. policies to the emerging market economies. In these countries, a tightening of U.S. monetary policy leads to a rise in global risk as well as an increase in country risk. These changes in the risk premia affect the domestic response to the U.S. policy. The advanced economies, on the other hand, do not show similar responses.

For example, in the empirical analysis Kalemli-Özcan finds that an increase in the U.S. Treasury rate leads to an increase in the differential with domestic government bond rates in her sample of 46 emerging market economies, but a decline in the same differential in her sample of 13 advanced economies. However, the differential in the emerging market countries falls when a measure of global risk aversion (VIX) is added to the analysis, and becomes insignificant when an indicator of country risk (Emerging Market Bond Index Global of JPMorgan) is also utilized.

Risk premia also affect the linkage of domestic policy rates and lending rates. The presence of risk injects a wedge between the two domestic interest rates. If domestic bank rates are regressed on the policy rate in the emerging markets, the pass-through is less than complete, whereas the pass-through is almost complete in the case of the advanced economies. But the impact in the emerging markets rises when the two indicators of risk are included in the empirical analysis.

Kalemli-Özcan infers that the central banks of the emerging markets loosen their policies when risk rises, and tighten when risk falls. This response is determined in part by the type of exchange rate regime that a country has. Those emerging markets that manage their exchange rates raise their policy rates in response to the increased risk premia following a U.S. tightening. These interest rate upswings in turn affect domestic economic activity. A flexible exchange rate regime, on the other hand, mitigates the undesirable effects of the risk spillovers by absorbing the response to the higher risk. The differences in exchange rate regimes, therefore, may explain the divergence in the responses of emerging market and advanced economies to U.S. policy shocks.

Both papers acknowledge that U.S. policies have significant effects on foreign economies. Albrizio, Choi, Furceri and Yoon conclude that U.S. monetary policy is a contributor to the “global financial cycles” that Rey (2015) and others have identified. Kalemli-Özcan finds that U.S. policies are a “powerful force in driving international risk spillovers.” While global trade flows may have fallen, capital flows until the coronavirus were robust. As long as the U.S. dollar is dominant in international commerce and finance, the Fed’s influence will continue to unsettle foreign nations.

The Search for an Effective Macro Policy

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Economic growth in the advanced economies seems stalled. This summer the IMF projected increases in GDP in these economies of 1.8% for both 2016 and 2017. This included growth of 2.2% this year in the U.S. and 2.5% in 2017, 1.6% and 1.4% in the Eurozone in 2016 and 2017 respectively, and 0.3% and 0.1% in Japan. U.S. Treasury Secretary Jack Lew has called on the Group of 20 countries to use all available tools to raise growth, as has the IMF’s Managing Director Christine Lagarde. So why aren’t the G20 governments doing more?

The use of discretionary fiscal policy as a stimulus seems to be jammed, despite renewed interest in its effectiveness by macroeconomists such as Christopher Sims of Princeton University. While the U.S. presidential candidates talk about spending on much-needed infrastructure, there is little chance that a Republican-controlled House of Representatives would go along. In Europe, Germany’s fiscal surplus gives it the ability to increase spending that would benefit its neighbors, but it shows no interest in doing so (see Brad Setser and Paul Krugman). And the IMF does not seem to be following its own policy guidelines in its advice to individual governments.

One of the traditional concerns raised by fiscal deficits rests on their impact on the private spending that will be crowded out by the subsequent rise in interest rates. But this is not a relevant problem in a world of negative interest rates in many advanced economies and very low rates in the U.S. The increase in sovereign debt payments should be more than offset by the increase in economic activity that will be reinforced by the effect of spending on infrastructure on future growth.

On the other hand, there has been no hesitation by monetary policymakers in responding to economic conditions. They initially reacted to the global financial crisis by cutting policy rates and providing liquidity to banks. When the ensuing recovery proved to be weak, they undertook large-scale purchases of assets, known in the U.S. as “quantitative easing,” to bring down long-term rates that are relevant for business loans and mortgages.The asset purchases of the central banks led to massive expansions of their balance sheets on a scale never seen before. The Federal Reserve’s assets, for example, rose from about $900 billion in 2007 to $4.4 trillion this summer. Similarly, the Bank of Japan holds assets worth about $4.5 trillion, while the European Central Bank owns $3.5 trillion of assets.

The interventions of the central banks were successful in bringing down interest rates. They also elevated the prices of financial assets, including stock prices. But their impact on real economic activity seems to be stunted. While the expansion in the U.S. has lowered the unemployment rate to 4.9%, the inflation rate utilized by the Federal Reserve continues to fall below the target 2%. Investment spending is weaker than desired, despite the low interest rates. Indeed, many firms have sufficient cash to finance capital expenditures, but prefer to hold it back. The situations in Europe and Japan are bleaker. Investment in the Eurozone, where the unemployment rate is 10.1%., remains below its pre-crisis peak. Japan also sees weak investment that contributes to its stagnant position.

If lower interest rates do not stimulate domestic demand, there is an alternative channel of transmission: the exchange rate, which can improve the trade balance through expenditure switching. But there are several disturbing aspects of a dependence on a currency depreciation to increase output (see also here). First, there is an adverse impact on domestic firms with liabilities denominated in a foreign currency, as the cost of servicing and repaying that debt rises. Second, expansionary monetary policy does not always have the expected impact on the exchange rate. The Japanese yen appreciated last spring despite the central bank’s acceptance of negative interest rates to spur spending. Third, a successful depreciation requires the willingness of some other nation to accept an appreciation of its currency. The U.S. seems to have accepted that role, but Mohammed A. El-Erian has pointed out, U.S. firms are concerned “…about the impact of a stronger dollar on their earnings…” He also points to “…declining inward tourism and a deteriorating trade balance…” Under these circumstances, the willingness of the U.S. government to continue to accept an appreciating dollar is not guaranteed.

There is one other consequence of advanced economies pushing down their interest rates: increased capital flows to emerging market economies. Foreign investors, who had pulled out of bond markets in these countries for much of the last three years, have now reversed course. The inflows may help out those countries that face adverse economic conditions. But if/when the Federal Reserve resumes raising its policy rate, the attraction of these markets may pall.

The search for an effective macro policy tool, therefore, is constrained by political considerations as much as the paucity of options. But there is another factor: is it possible to return to pre-2008 economic growth rates? Harvard’s Larry Summers points out that those rates were based on an unsustainable housing bubble. He believes that private spending will not return us to full-employment, and urges the Fed to keep interest rates low and the government to engage in debt-financed investments in infrastructure projects. Ken Rogoff (also of Harvard), on the other hand, believes that we are suffering the downside of a debt supercycle. Joseph Stiglitz of Columbia University blames deficient aggregate demand in part on income inequality.

The one common theme that emerges from these different analyses is that there is no “quick fix” that will restore the advanced economies to some economic Eden. Structural and other forces are acting as headwinds to slow growth. But voters are not interested in long-run analyses, and many will turn to those who claim that they have solutions, no matter how potentially disastrous those are.

 

Monetary Policy in an Open Economy

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The recent research related to the trilemma (see here) confirms that policymakers who are willing to sacrifice control of the exchange rate or capital flows can implement monetary policy. For most central banks, this means using a short-term interest rate, such as the Federal Funds rate in the case of the Federal Reserve in the U.S. or the Bank of England’s Bank Rate. But the record raises doubts about whether this is sufficient to achieve the policymakers’ ultimate economic goals.

The short-term interest rate does not directly affect investment and other expenditures. But it can lead to a rise in long-term rates, which will have an effect on spending by firms and households. The relationship of short-term and long-term rates appears in the yield curve. This usually has a positive slope to reflect expectations of future short-term real rates, future inflation and a term premium. Changes in short-term rates can lead to movements in long-term rates, but in recent years the long-term rates have not always responded as central bankers have wished. Former Federal Reserve Chair Alan Greenspan referred to the decline in U.S. long-term rates in 2005 as a “conundrum.” This problem is exacerbated in other countries’ financial markets, where long-term interest rates are affected by U.S. rates (see, for example, here and here) and global factors.

Central banks that sought to increase spending during the global financial crisis by lowering interest rates faced a new obstacle: the zero lower bound on interest rates. Policymakers who could not lower their nominal policy rates any further have sought to increase inflation in order to bring down real rates. To accomplish this, they devised a new policy tool, quantitative easing. Under these programs, central bankers purchased large amounts of bonds with longer maturities than they use for open market transactions and from a variety of issuers in order to bring down long-term rates. The U.S. engaged in such purchases between 2008 and 2014, while the European Central Bank and the Bank of Japan are still engaged in similar transactions. As a consequence of these purchases, the balance sheets of central banks swelled enormously.

In an open economy, there is another channel of transmission to the economy for monetary policy: the exchange rate. If a central bank can engineer a currency depreciation, an expansion in net exports could supplement or take the place of the desired change in domestic spending. A series of currency depreciations last summer led to concerns that some central banks were moving in that direction.

But there are many reasons why using exchange rate movements are not a solution to less effective domestic monetary policies. First, if a central bank wanted to use the exchange rate as a tool, it would have to fix it. But it then would have to surrender control of domestic money or block capital flows to satisfy the constraint of the trilemma. Second, there is no simple relationship between a central bank’s policy interest rate and the foreign exchange value of its currency. Exchange rates, like any asset price, exhibit a great deal of volatility. Third, the impact on an economy of a currency depreciation does not always work the way we might expect. Former Federal Reserve Chair Ben Bernanke has pointed out that the impact of a cheaper currency on relative prices is balanced by the stimulative effect of the easing of monetary policy on domestic income and imports.

Of course, this does not imply that central banks need not take notice of exchange rate movements. There are other channels of transmission besides trade flows. The Asian crisis showed that a depreciation raises the value of debt liabilities denominated in foreign currencies, which can lead to bankruptcies and banking crises. We may see this phenomenon again in emerging markets as those firms that borrowed in dollars when U.S. rates were cheap have difficulty in meeting their obligations as both interest rates and the value of the dollar rise (see here).

Georgios Georgiadis and Arnaud Mehl of the European Central Bank have investigated the impact of financial globalization on monetary policy effectiveness. They find that economies that are more susceptible to global financial cycles show a weaker response of output to monetary policy. But they also find that economies with larger net foreign currency exposures exhibit a stronger response of output to monetary policy shocks. They conclude: “Overall, we find that the net effect of financial globalization since the 1990s has been to amplify monetary policy effectiveness in the typical advanced and emerging markets economy.”

While their results demonstrate the importance of exchange rate in economic fluctuations, that need not mean that monetary policy is “effective” as a policy tool. As explained above, flexible (or loosely managed) exchange rates are unpredictable. They can change in response to capital flows that react to foreign variables as well as domestic factors. The trilemma may hold in the narrow sense that central banks maintain control of their own policy rates if exchange rates are flexible. But what the policymakers can achieve with this power is circumscribed in an open economy.