U.S. Monetary Policy: Slowly Moving Toward the Exit in an Interconnected Global Economy

Donald Kohn delivered the keynote address at the Bank of Thailand-IMF Conference: Monetary Policy in an Interconnected Global Economy, which took place November 1, 2013. His remarks on the Federal Reserve and its exit from unconventional monetary policies are below.

We’ve had a vivid demonstration over the past six months of the effects of shifting expectations about U.S. monetary policy on global financial markets. To be sure, many other factors were also responsible for the gyrations in bond and equity prices and exchange rates over this time period—including importantly greater optimism about prospects in a number of advanced economies and increased concerns about the economic fundamentals of a number of emerging market economies. But the effects of Federal Reserve communication and action—or inaction—on market participants’ perceptions of how quickly the Fed would exit from its unconventional monetary policies involving its portfolio expansion and its zero policy interest rate played an important role.

It’s not surprising that the monetary policy of the issuer of the most prominent reserve currency for the world’s largest economy, a currency in which many global transactions are denominated, would have sizable effects on prices across a wide swath of financial markets. And it that context, I thought it would be useful for you if I used this occasion to discuss the factors bearing on the outlook for U.S. monetary policy, the challenges of communicating about that policy, and the implications of global interconnections for that policy and for those facing a slow uncertain exit from U.S. UMP. I have seven points I’m going to develop.

1. That the Federal Reserve is having a discussion about its exit from UMP in the U.S. is mostly good news. The U.S. economy has recovered considerably from the deep recession and is poised for further gains. GDP has recovered to its previous peak, though it is still very far below the economy’s potential to produce. The unemployment rate has fallen around three percentage points to 7-1/4, still close to 2 percentage points above its estimated long-run sustainable rate.

Considerable progress has been made in redressing a number of the imbalances that gave rise to the cycle and whose correction has held back the recovery. The balance sheets of both borrowers and lenders have been strengthened considerably. On the borrower side, household debt to income ratios are down considerably—through both weak borrowing and default on previous loans– and debt service obligations are at record lows reflecting low interest rates as well as reduced debt. Lenders have rebuilt capital and are making credit more available for a variety of borrowers.

The build up of debt in the boom years financed an excess supply of houses and consumer durables, like autos, and those excesses also seem to have been worked off by a combination of very low levels of production and continued population growth. Even after recent gains, home building and production of consumer goods and services have further to rise to keep pace with population growth, much less to fill any pent up demand that developed over the lean years.

As in many countries, fiscal consolidation has restrained economic growth in the U.S. This has occurred on state and local as well as federal levels. States and localities are still facing considerable challenges, especially those with insufficiently funded pension obligations, but the pressure has abated and in the aggregate these governments, which had laid off many workers, appear to be hiring again. Rising taxes and declining spending on the Federal level are estimated to have taken about 1-1/2 percentage points off growth in 2013. One hesitates to make any prediction about what our highly polarized and poorly functioning legislative process will yield in the future, but the most likely outcome is for considerably less consolidation in 2014 now that deficits have been reduced, cutbacks in government services have been implemented, and debt to GDP levels are stabilizing.

Against this background, most observers, including the IMF, are predicting a pick up in growth next year in the U.S. and a more rapid erosion of unused margins of resources.

2. I characterized the exit discussion as only “mostly” good news because some of the pressure for reducing asset purchases comes from concern about the possible adverse consequences of balance sheet expansion, not confidence that the economy is on a sustained growth track toward full utilization of labor and capital resources. For example concerns have been expressed about the effects of an ever-expanding Federal Reserve balance sheet on trading liquidity and market functioning as the central bank takes greater proportions of the new issuance of Treasury and agency securities and removes this valuable collateral from further use in the market place.

Worries about the broader implications of further purchases for financial stability also have come into consideration. One of the purposes of quantitative easing is to increase the supply of credit to riskier borrowers by inducing savers to rebalance their portfolios out the duration and risk curves. But if they begin taking risks they don’t appreciate, and in particular if financial intermediaries become exposed to a reversal in longer-term rates and credit spreads or to a twisting of the yield curve, the functioning of the financial system could be at risk and the response to exit highly nonlinear. We’ve already seen evidence of an outsized effect from expected exit in the reactions in the financial markets of some emerging market economies. To be sure, sustained low policy interest rates themselves can also increase the risk of building vulnerabilities, but that risk is accentuated by the downward pressure on term premiums from central bank purchases, with perhaps less effect boosting spending.

And some policy makers appear concerned that further substantial portfolio expansion will complicate exit and expose the balance sheet and income statement of the Federal Reserve.

So far, in my view the benefits of portfolio expansion have outweighed the costs. But one of the those benefits arose from the signaling effect of purchases—that is the intent of the Federal Reserve to follow a highly accommodative policy for quite a while until better economic performance was assured. Now, the Federal Reserve and other central banks have developed better, more explicit, means to signal their rate intentions—that is, forward guidance tied to economic conditions. The Fed will hold interest rates near zero at least until the unemployment rate drops below 6-1/2 percent, provided inflation is predicted to remain below 2-1/2 percent. With the signaling effect of QE less important, and with concerns about the costs of portfolio expansion, the Federal Reserve will be less reluctant to reduce its purchases and will rely more on forward guidance to influence interest rates.

3. Although the rollback of purchases is likely to start within the next six months, exit from the other aspect of UMP—zero policy interest rates—will take much longer. The U.S. economy has yet to evidence consistent growth appreciably above the growth rate of its potential and substantial output and employment gaps persist. Fiscal policy should be much less of a drag next year, but it won’t be adding to aggregate demand—only subtracting less—and the other factors have been holding back growth will continue to dissipate slowly.

Household balance sheet repair is incomplete, and those households that have experienced debt problems will be reluctant to borrow and will have reduced access to new credit for a time. In the real estate sector credit is still quite tight for many borrowers. Enhanced supervision and regulation, and higher capital and liquidity buffers for financial intermediaries are necessary to build greater systemic resilience, but internalizing externalities of financial stability are raising the costs of intermediation.

And slow progress on global rebalancing is also holding back the normalization of interest rates. Evidently, global demand is not strong enough to place global output close to its potential, but we cannot go back to relying on debt-financed spending by the U.S. (or European peripheral countries) to drive the global economy; that movie ended badly. The U.S. must shift the composition of its demand at full employment from consumption and residential investment to business investment and exports. That means that other countries cannot count on exports to the U.S. and other deficit economies to fuel their growth but rather the surplus countries must boost their domestic demand to replace the cutbacks from the U.S. and other current account deficit countries. That process is far from complete.

I think you should anticipate a long period of very low rates in the U.S. and many other advanced economies, with slow, probably halting, increases thereafter.

4. It would helpful in terms of preparation and market volatility if the Federal Reserve could reduce uncertainty through “clear communication and predictable action”, but both we and the Federal Reserve need to recognize the natural limits on predicting monetary policy actions or even specifying monetary policy reaction functions. To be sure, the Fed could have done better in its communications over the past six months. But to some extent, the miscommunication and misinterpretation may have arisen from the Fed trying too hard—trying to be more transparent and predictable than is desirable or possible in an uncertain world about policy made by a committee—and from the rest of us not making allowance for the challenges involved.

We are living in a particularly uncertain economic environment. Except for Japan, we have no recent experience with a severe financial crisis followed by a prolonged slump in advanced economies. And this experience has vividly demonstrated that our understanding of many basic economic relationships is incomplete at best, and not only at the intersection of financial markets and the real economy. Moreover, we are employing monetary policy instruments—UMP—for which we have no precedent. And there are many policy levers in use at the same time; the Fed and other central banks are using portfolio tools and trying to shape policy expectations in new ways.

The Federal Reserve and we need to be especially humble about our predictions for the economy, about the relationships of these predictions to evolving financial conditions, and about the relationship of financial conditions to policy actions and words. Forecasts are subject not only to the usual types of shocks, but to substantial uncertainty about the basic structure of the underlying models as well as the specification of their parameters. As a consequence, central banks may find themselves changing their minds about tying policy to particular metrics of the state of the economy—as the Federal Reserve appears to have done with respect to the importance of the unemployment rate for ending its purchase program.

The difficulty of pinning down one particular view of the world as obviously better than another is reflected in the range and persistence of diverse views within the Federal Reserve about how to achieve agreed objectives. Bringing alternative perspectives to bear is the reason to create committees to make policy decisions. But when the holders of those views speak out, it can make it difficult for we outsiders to figure out what the committee as a group is likely to decide.

That difficulty is compounded by a diversity views on basic choices for monetary policy strategies. The FOMC has agreed a “balanced approach” to its dual mandate for employment and prices in which the setting of the policy rate or other instrument depends on the extent to which employment and inflation each deviates from its objective, with the largest gap getting the most weight. But within that broad framework, differences in approach have emerged. Some FOMC members would like to put extra weight on the output gap, and might contemplate seeking to overshoot the inflation target to get that gap down, as in optimal control or nominal GDP exercises; they would delay exit from UMP. Others seem to be quite concerned about the financial stability aspects of UMP and they would be willing to exit earlier, in effect settling for missing employment and inflation targets on the low side in the medium term to reduce the odds on instability over the longer run. And of course there are a range of views between those two.

5. So exit is likely to be difficult to predict and to communicate about clearly and this is likely to produce some added volatility as well as pressures on global interest rates and exchange rates as the Federal Reserve moves slowly toward the exit. To a considerable extent, such volatility and pressures would be a natural and expected effect of any tightening of policy by the Federal Reserve, including an increase in the federal funds rate, especially a tightening that is expected to initiate a series of such actions. Rising interest rates—putting upward pressure on foreign rates– and an appreciating exchange rate are key channels through which firmer policy in the U.S. damps demand and constrains inflationary impulses. As exit from portfolio expansion and especially subsequently from zero rates draw closer and higher rates become more prominent components of yield curves, yield curves will steepen globally.

And there are reasons to wonder whether these effects might not be amplified because they follow such a long period of UMP. Both purchases and promises of zero interest rates into the future have damped volatility; and the drop in term premiums and extended period of zero interest rates may be encouraging investors and intermediaries to build risk positions that are especially vulnerable to rising long-term rates and increased risk premiums. The reversal of these positions could well spark outsized reactions in financial market prices from time to time—and we saw in the May-July period. The Federal Reserve is trying to manage the dual exits more smoothly, in part by differentiating portfolio decisions from forward guidance and shifting to rely more on the latter as it prepares to reduce purchases. That should help to damp volatility and hold down longer-term rates. But periods of volatility may be inevitable given the difficulty of shaping expectations with communication in an uncertain and unprecedented economic and policy environment.

6. The Federal Reserve is not likely to change its course of action because of spillovers to other countries, beyond taking account of the effects of these spillovers back on the U.S. economy. The Federal Reserve’s legislated mandates are for maximum employment and stable prices in the United States. The IMF spillover analysis is very helpful background for international discussions of policy interactions. But the Federal Reserve would be, rightly in my view, highly skeptical about cooperative solutions that take risks with these domestic objectives to take account of spillovers to other countries based on the commitments of other countries to follow particular policies. The gains from cooperation could well be small and the commitments on which such solutions might be based would be difficult to enforce and to adapt subsequently to rapidly changing circumstances.

The global economy will be best served by a strong and stable U.S. economy, and fostering that will go a long way toward fostering a strong and stable global economy, especially if global growth is better distributed so countries aren’t in large and potentially destabilizing current account deficits and surpluses. If the Federal Reserve had hesitated to ease further through UMP in recent years because of concerns about spillovers, the U.S. economy would have been weaker, deflation a greater threat, and the global economy even less robust. Analogously, hesitating to tighten out of concern about effects on other economies will risk inflation in the U.S. and more forceful and disruptive tightening later.

7. It will be up to the individual countries and currency areas facing U.S. monetary policy exit to adapt. That will require strong financial systems that are robust to shifting yield curves and currency values. Much progress has been made in oversight of banking systems, but one lesson from the experience of the U.S. is that nonbank finance also needs to be resilient to unexpected developments. For example, corporate bond issuance has increased rapidly in many emerging market economies and holders of those bonds will be vulnerable to unexpected increases in interest rates. If ownership is widely dispersed, not concentrated and not financed with short-term borrowing, it’s not a threat to financial stability—but do we know that.

It will also require an ability to control overall financial conditions whatever the Federal Reserve decides to do. That in turn will entail a high degree of exchange rate flexibility, offset if necessary with monetary or fiscal restraint if declining exchange rates threaten overheating. Allowing one-way bets to cumulate behind inflexible but unsustainable exchange rates will risk a larger and more disruptive adjustment later on. To be able to adjust monetary and fiscal policy in a credible way rests in turn on sound and credible longer-run policy frameworks.

I suspect what you are thinking right now is: robust financial systems, sound long-run policy frameworks–easier to say than to do and advice not always followed by the U.S. I agree. But we all need to learn from our mistakes if we are to climb out of this global slump and to do so without precipitating other problems as interest rates rise. I hope my talk today has given you some insight into what you are likely to be facing from U.S. monetary policy in the next few years and will help with your preparations.