On the Record

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

Donald Kohn

As a small open economy with open capital markets, Singapore is greatly exposed to developments in the global economy. Among the many such influences is monetary policy, especially in large industrial economies that also have open capital markets so that the impulse from those policies shapes global capital flows. And that influence has been particularly marked with policy rates at zero in many countries, with the resulting capital flows eventually finding homes in places like Singapore.

In the spring of 2013, when expectations that the Federal Reserve might soon begin taking its initial steps to exit from its unusual monetary policies of asset purchases and zero interest rates were roiling global markets, Ravi Manon, managing director of the Monetary Authority of Singapore, remarked that “monetary policy has become interesting again.” I dare say it has become even more fascinating in the time since then as the Fed has taken actual steps toward the exit, while the Bank of Japan and European Central Bank have been required to double down on their unconventional policies to fight stagnation and persistent below-target inflation.

In my talk today, I thought it would be useful for me to discuss U.S. monetary policy. I will put it in the context of the outlook for the U.S. economy, but also of global developments—not only as those developments affect U.S. monetary policy, but also as that policy affects global markets. What can we expect? Are there ways to mitigate the risks to the global financial markets from disparate monetary policies in the world’s largest economies?

The U.S. economy and monetary policy

That the Federal Reserve feels comfortable taking steps to exit from unconventional policies of course is very good news. The U.S. economy has made steady progress out of the very deep recession that followed the rolling financial market crisis of 2007-08, albeit much more slowly than had been hoped or anticipated. Economic slack—underutilized labor and capital resources–have been greatly reduced. The unemployment rate has fallen to a little over 5-1/2 percent, just above the upper end of estimates of the long run sustainable unemployment rate in the U.S. economy; and the utilization of industrial capacity is now around its long-run average. The inflation rate, abstracting from the effects of energy price declines, has moved up from very low levels toward the Federal Reserve’s 2 percent target, though its upward movement has stalled out and it still remains well below that level.

At the end of 2013, the Fed was comfortable enough with the progress in putting people back to work and confident enough that progress would continue to announce that it would gradually phase down its purchases of long-term Treasury and mortgage backed securities. Sizeable gains in employment continued in 2014, and the Fed tapered off its purchases, ending them and capping its portfolio last October. Those holdings remain very large, keeping downward pressure on long-term rates, but the Fed no longer feels the need to increase the pressure by adding to its holdings. To be sure, communication about the end of so-called QE hasn’t always been easy–there were some hiccups in the spring and summer of 2013, but in the event, it was executed smoothly with no disturbance to financial markets.

But if one aspect of unconventional monetary policy in the U.S.—asset purchases—has been capped, another remains in place. Policy interest rates remain near zero and the Fed continues to try to steer the bond market by promising to keep them there for a while longer—to be “patient” in deciding when to begin raising rates. That decision is now being tugged in two different directions by actual and prospective developments in the U.S. economy.

On the one hand, economic growth appears to have picked up some and the labor market is strengthening faster. After the first quarter of 2014 when output and employment were reduced by adverse weather, the U.S. economy has grown quite rapidly, by the standards of recent years. And that growth has been accompanied by more rapid increases in employment and substantial reductions in the unemployment rate.

A number of factors lie behind this improved performance: Borrower and lender balance sheets are in much better shape, and credit is flowing easily again to most sectors at very low interest rates; contributing to the improvement in household balance sheets has been an increase in equity and house prices, bouncing back from depressed levels and responding to extraordinarily low interest rates; the overhang of excess houses has been worked off, and as soon as household formation picks up—the kids move out—the uptrend in housing construction will pick up momentum; and increases in employment have fed greater increases in income. Importantly, fiscal policy is no longer constraining growth: In 2012 and 2013 increases in taxes and cuts in government spending at the federal level were a substantial drag on demand; and federal government fiscal restraint was occurring at a time when state and local governments were also cutting back. That restraint from all levels of government ebbed over 2014, and fiscal policy will be neutral to possibly supplying a slight tailwind in 2015.

Prospects going forward are even better. The decline in energy prices is adding to the disposable income of households. Both household and business confidence is on the rise, and we know how important these animal sprits are to growth. Many of those forecasting U.S. growth have revised up their projections; the IMF for example increased its projection of U.S. growth for 2015 to 3-1/2 percent with growth dropping back only to 3-1/4 percent in 2016. Both of these growth rates are substantially in excess of the increase in potential output in the U.S. of around 2 percent or so and if realized would tend to push the unemployment rate well through the levels previously thought consistent with keeping inflation stable. It’s this prospect that has the Federal Reserve and most observers anticipating that it will begin to raise rates sometime this year.


What’s holding them back? Why hasn’t the Fed already begun increasing rates in light of this outlook? In a word, inflation, including questions about whether and how fast it will rise in the U.S., even if growth remains above potential. Headline inflation has come way off, mostly because of the declines in energy prices and the drop in the prices of other imports as the dollar has strengthened. And because those prices have continued to move lower, inflation is likely to remain quite low or even fall further in the months ahead. However, the Fed will look through the direct effects of oil and import prices. By themselves, they are indicative of changes in price levels not of continuing disinflation or dangers of deflation. Energy prices won’t fall and the dollar won’t rise forever; eventually these prices will level out or even reverse a portion of their recent movements. Instead, the focus will be on underlying inflation rates likely to emerge when the adjustment to energy prices and the dollar are finished. And in that regard there are signs that underlying inflation rates have not been moving toward the two percent target, certainly not as quickly as might be expected given the approach of the unemployment rate and capacity utilization toward levels that in the past had been associated with reasonably full employment.

One possibility is that the unemployment rate we usually look at isn’t representative of the true state of the labor market. Workers who have dropped out of the labor force in this long slow recovery or who have taken part time jobs when they wanted full time jobs are available and ready to work and are a potential source of labor supply, even though they don’t count in the usual unemployment rate. In effect, the sustainable unemployment rate might be lower than we thought—at least for a while. The data on wages and labor costs are quite mixed; some measures show the sort of pick up you’d expect as the unemployment rate has dropped to relatively low levels, but others remain very weak. The Fed will be monitoring labor costs carefully to judge just how close to full employment the U.S. is.

Another possibility is that these drops in energy and import prices are—or might—feed through to underlying inflation on a more persistent basis through second-round effects. A key channel for this type of effect would be through inflation expectations—not so much through the expectations of inflation in the near-term, which we know will be held down by energy price declines, but by expectations about inflation once the energy price decline has passed through the system. If people come to expect very low inflation over a long period, they will adjust wages and prices accordingly in a self-fulfilling feedback. The evidence here also is mixed. Surveys—mostly of households and economists—do not show any real slippage in long-term inflation expectations. But those derived from the financial markets, the gap between nominal and real interest rates, have come off considerably. There may be some special reasons for this, but inflation expectations are another factor the Fed is watching carefully.

It will be some months before the Federal Reserve is likely to be able to sort through these influences on inflation, and that’s why most observers don’t expect it to raise rates before midyear, and possibly for several months thereafter. When it does finally raise rates, it will want to be fairly confident it is the right thing to do. Raising rates too early and slowing the economy too much or stopping the rise inflation before it has enough momentum to get to the 2 percent target would be a difficult mistake to correct. Not only would the rate rise need to be reversed, but unconventional policy measures, like asset purchases might have to be restarted, to uncertain effect. We’ve already seen how hard it is to re-energize an economy when interest rates are already extremely low. The Fed will not want to be too late with its rate rise, but that’s an easier mistake to correct. If it appears that by waiting too long to tighten, the Federal Reserve has allowed inflation pressures to build more than is desirable, the Federal Reserve can just raise interest rates faster, which will damp demand and keep the economy and inflation from overshooting.

Global Interconnections

So far, my discussion has referred to global interconnections only in passing, but they are critical to understanding the challenges facing U.S. monetary policy as well as the challenges U.S. monetary policy may pose to the rest of the world. I will start with the effects of global developments on the U.S. economy and monetary policy.

Slower growth outside the U.S. together with a much stronger dollar will take something off U.S. growth this year. Because the U.S. is not a very open economy—exports are less than 15 percent of GDP—the net effect of those factors should not be large, provided reactions are reasonably close to average historic experience. The upward revisions in U.S. growth estimates I referenced earlier have been made following most, though not all, of the recent dollar strength.

Moreover some of the upward movement in the dollar reflects more aggressive monetary policy actions by the ECB and other central banks to counter economic weakness and disinflationary impulses. Those policies should help to bolster global growth, offsetting the effect of the stronger dollar on the U.S. Easier monetary policy for a sluggish economy is not a zero sum game. Monetary policy operates in part through an exchange rate channel to be sure, but other mechanisms are at work, including lower interest rates, higher asset prices, and not least, greater confidence about the future and a willingness to take risks–in capital investment as well as the allocation of savings. Sluggish euro area or Japanese economies and extremely low inflation or deflation there pose greater risks to the global economy than do the exchange rate movements that result from more accommodative monetary policies.

Still, concerns about developments beyond the U.S. borders are probably one factor behind the Fed’s patience in raising rates. Some of the strength in the dollar reflects safe-haven flows into the U.S. in a turbulent economic and political world as well as pessimism about economic prospects elsewhere—perhaps because of doubt about the effectiveness of recent monetary policy actions–and these are negative influences on U.S. expansion. And some of the drop in oil prices reflects weaker global demand in addition to increased supplies. At a minimum, the downside risks to U.S. growth from overseas are sizable, especially when so much of the industrial world seems to be struggling to generate adequate demand while a number of emerging market economies are downshifting or facing problems of their own. Weak global demand has been generating a strong disinflationary impulse, which is only added to by the supply side shock of greater oil production. No wonder the Federal Reserve is looking for greater confidence that inflation in the U.S. will rise toward its 2 percent before it will begin to exit from its zero interest rate policy.

We seem to be in a pattern of global growth in which strength in the U.S. is being counted on as an important element supporting global demand. I find this pattern worrisome. The U.S., especially the U.S. household, was the “demander of last resort” for the global economy in the mid 2000s. The result was a rising current account deficit and a buildup of debt; the normal equilibration mechanism of a fall in the dollar and higher interest rates was damped by capital inflows, partly reflecting demands for safe assets (many of which, like AAA-rated MBS tranches turned out not to be so safe), and partly reflecting the export-led growth models of some countries and their investment of proceeds from intervention to suppress currency appreciation.

As we saw all too vividly, that was not a sustainable situation and it is one we don’t want to repeat. A more sustainable global expansion would rely more on current account surplus countries to boost domestic demand through fiscal or structural policies. That’s happening to some extent, but not quickly enough to strengthen global demand sufficiently and the consequence is the global disinflationary pressure I spoke of earlier.

To counter that pressure and the particular problems besetting their economies, a number of important central banks, including the ECB and BoJ, have intensified their unconventional monetary policies. Meanwhile, as I’ve been discussing, the Fed in the U.S. appears to be getting ready to raise rates. Having monetary policies moving in different directions in various places is not unusual; it’s normal for countries to be in different stages of the business cycle and monetary authorities to be responding to that economic divergence with appropriately calibrated policies. And it is normal—indeed desirable—for divergent monetary policies to be reflected in exchange rate movements.

What is not normal is that this divergence in policies is coming after a period in which the monetary authorities in so many industrial economies have been in synch–running highly accommodative policies trying to stimulate their economies and raise inflation to target at the same time; in which they were doing this with highly unusual policies—zero interest rates and purchases of long-term assets; and, with few interruptions they have been at this for a long time—ever since the fall of 2008. We are in uncharted waters. We don’t know to what extent the resulting capital flows, portfolio choices, and asset price relationships are overextended and likely to reverse quickly and possibly disruptively as some rates rise while others are driven still lower. We can count on considerably more volatility and wider risk spreads as people adjust to the changing financial landscape. But that follows a period in which many worried that low-for-long monetary policies had induced a “search for yield” that had driven risk spreads and volatility lower than is sustainable, with investors taking risks they may not have understood or evaluated correctly.

The global financial authorities have made major strides in making their systems more resilient to unexpected developments, in particular with higher capital and greater liquidity for banks and bank holding companies. In several jurisdictions, banks have been stress tested with scenarios that included rising rates. Moreover, we’ve seen several episodes in which volatility and risk spreads have risen, including the summer of 2013 during the so-called taper tantrum, and in the past few months amid mounting uncertainty about global economic prospects, plunging oil prices, growing political and economic tensions in the euro area, and strong monetary policy responses. Although there’s been some fallout from these financial market developments, none has threatened financial stability.

Still, this could be a testing time for the global financial system as prices and flows adjust to the changing reality. A substantial amount of credit has been flowing into bond markets through mutual funds and ETFs; bond market liquidity appears to have been reduced since the crisis, and when investors in these types of managed funds realize the potential for large price movements in response to redemptions it may fuel an even stronger desire to sell the funds and an associated fire sale. Riskier borrowers, such as below investment grade businesses in the U.S. and emerging market businesses borrowing in dollars, have found credit especially readily available, perhaps as investors looked around for higher yield assets in a low interest rate world. Some rise in dollar interest rates and the dollar exchange rate is to be expected as U.S. monetary policy firms; indeed higher interest and exchange rates are ways tighter policy is transmitted to the economy to restrain incipient inflation pressure. But an unexpectedly sharp rise in rates or increase in volatility could reveal weaknesses and mismatches among these borrowers that have not been anticipated by investors. And the effects could be especially felt in emerging market economies, which had been the recipient of so much of the flows seeking higher yields.

Because the important players among financial intermediaries are so much stronger, we shouldn’t see types of contagion that so often characterize systemic financial crises, like that of 2007-08. But there may well be surprises and strong reactions in prices and flows, with implications for a number of markets and economies. And this possibility raises the question of what might be done—by the Federal Reserve and other central banks—to reduce the odds on nasty surprises as they carry out divergent monetary policies.

Let me start by talking about what won’t be done. The Federal Reserve will of course react to the effects of its actions on markets and economies to the extent those effects feed back on the U.S. in ways that jeopardize its pursuit of stable prices and high employment. And so too will the ECB and the BoJ and other central banks adjust policies as financial and economic conditions evolve. But they are not likely to defer or change their course of action because of potential spillovers to other countries, beyond taking account of the effects of these spillovers back on their own domestic economies. Raghu Rajan, the governor of the Reserve Bank of India, and others have argued that the Fed and other industrial economy central banks should cooperate more in their policies and adjust them to reduce these spillovers on third parties.

But the Federal Reserve’s legislated mandates are for maximum employment and stable prices in the United States. And those are the objectives for which it is held responsible and accountable in a democracy. The Federal Reserve would be, rightly in my view, highly skeptical about agreeing to cooperate explicitly with other countries to adjust policies in ways that take risks with these domestic objectives to reduce spillovers to other countries based on the commitments of other countries to follow particular policies. The potential gains from those sorts of cooperation are likely to be small even under ideal conditions and the commitments on which such solutions might be based would be difficult to enforce and to adapt subsequently in rapidly changing circumstances.

The global economy will be best served by a strong and stable U.S. economy, euro area economy, etc., and fostering that will go a long way toward fostering a strong and stable global economy. If the Federal Reserve had hesitated to ease further through unconventional monetary policy 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.

It would helpful in terms of preparation and market volatility if the Federal Reserve and other central banks could reduce uncertainty through “clear communication and predictable action”. Accidents and instability are most likely to occur when people are surprised. When markets can anticipate central bank actions accurately, they can adjust and work with the central banks to reinforce the intended effects of their actions. Central bank transparency can help to foster both monetary policy and financial stability objectives.

However, both we as observers and the central banks 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 in the summer of 2013. 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 possible in an uncertain world—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, until 2008 we had no recent experience with a severe financial crisis followed by a prolonged slump in advanced economies. And this recent experience has vividly demonstrated that our understanding of many basic economic relationships is incomplete at best, including at the intersection of financial markets and the real economy. Neither the central banks nor the private sector have done very well at predicting output, employment and inflation in recent years. Moreover, we are employing monetary policy instruments 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.

So, 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 how financial conditions might react to policy actions and words. Forecasts are subject not only to the usual types of unanticipated events, but also to substantial uncertainty about the basic structure of the economy, including how inflation might respond to particular unemployment rates. This presents great challenges to “forward guidance” about future interest rates. Unable to adjust policy rates downward, central banks have become increasingly explicit about their plans for adjusting—or not adjusting—policy rates in an effort to reduce longer-term interest rates, or prevent them from moving up prematurely.

Central banks need to strike the right balance between commitment to prevent unwanted increases in long-term rates and flexibility to react as new information about the economy and its structure become available. And we can’t expect more specificity and commitment about future rates than is healthy to give. In this uncertain and ever changing economic environment, we are likely to be surprised by some central bank actions from time to time, but if that surprise occurs in the context of a basic understanding of the goals and strategy of the central bank, it shouldn’t be destabilizing.

Ultimately 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. As I noted, 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.

More generally, oversight of financial systems needs to take account of interconnections and vulnerabilities of the entire system—beyond just looking at individual institutions. Singapore has been in the forefront of implementing this so-called macroprudential policy in response to growing threats from capital inflows, especially as they affect the housing market and credit flows into that market. In the UK, the Financial Policy Committee, of which I am a member, has also acted to guard against the build up of risks in lending against rising house prices. Macroprudential policy in one form or another has been around for some time, but we are just learning how to implement it in globally interconnected markets.

Sustaining growth and stability in the face of increases in volatility and surprises in asset prices will also require ability to control overall financial conditions whatever the Federal Reserve or other industrial economy central banks decide to do. I recognize that Singapore has successfully implemented a crawling peg exchange rate system. But for most countries such control 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.

Global financial markets and economies have come through a very turbulent period in recent years, and it looks like there may be more bumps to come. I noted at the beginning of my talk it is very good news that the Federal Reserve believes that the U.S. economy is robust enough that economic and price stability will soon require an increase in interest rates. At the same time we should wish every success to the ECB, BoJ, and other central banks using unconventional means to stimulate their economies and avoid deflation. Flexible economies, sound policy frameworks, and robust financial sectors is what we all will need to come through this period and restore global growth and price stability. Singapore has been in the forefront in this regard. I hope my discussion today will help you anticipate and prepare for what might lie ahead.