Geithner: U.S. Monetary Policy in the Global Financial Environment

Tim Geithner on making global monetary policy without a reliable compass:

U.S. Monetary Policy in the Global Financial Environment - Federal Reserve Bank of New York: Timothy F. Geithner, President and Chief Executive Officer Remarks at the Japan Society Corporate Luncheon in New York City:

I will focus on two features of what is happening in the world economy and financial markets today that are among the most interesting and consequential of the many questions we face today in thinking about the changes in the world economy and the task of central banking. These are, first, the behavior of forward interest rates in financial markets, and, second, the pattern of external imbalances....

When Alan Greenspan first used the term “conundrum” to describe the surprising behavior of forward interest rates, he was reacting to the decline in forward nominal rates over a period in which the Federal Open Market Committee was raising its federal funds target rate. This behavior of forward rates, the counterpart of which is the behavior of the bond yield curve, looked anomalous both in comparison to observations from past tightening cycles and with what seemed to be strong evidence about the fundamental soundness of the outlook for the real economy.

The source of the relatively low level of nominal rates is still a matter of considerable debate....

The other surprising feature of the current economic environment is the pattern of global imbalances.... As Alan Greenspan has explained, the greater dispersion in external imbalances can be seen as the inevitable result of fundamentally healthy changes in the world economy. As the world progresses toward increasingly integrated financial and goods markets, other things being equal, one might expect to see an increase in the number of countries with surpluses or deficits, and potentially larger surpluses and deficits, as flows of both financial assets and goods work to equalize desired saving and investment around the world.

If one were confident that observed imbalances simply reflected a more efficient allocation of the world’s stock of saving to its most productive uses, that relative prices adjust freely in response to changing fundamentals and that economies are flexible and agile in adapting to those changes, then we might also reasonably expect these imbalances to resolve themselves through smooth and gradual adjustments in relative prices and flows of goods and services. These conditions do not fully exist today....

One feature of present conditions that is not captured by these explanations and that is likely to be playing a significant role in contributing to the combination of these large imbalances and relatively low forward interest rates is the pattern of exchange rate and monetary policy arrangements in the global economy today.... [A] substantial part of the world economy now run monetary policy regimes targeted at limiting the variability in their exchange rate against the dollar, or a basket in which the dollar plays a substantial role. Sustaining that objective in the past several years has required a large accumulation of dollar assets. The scale of this activity has been particularly dramatic in parts of Asia.... These flows add to other sources of private demand for U.S. assets. At the margin, they put downward pressure on U.S. interest rates and upward pressure on other asset prices. Through this effect, the monetary policy regimes that prevail in parts of the world help explain at least part of the persistence of these anomalies. Recognizing that we live in a world where major exchange rates do not move freely against the dollar, means that the dollar is not as flexible as we tend to think. And understanding that the effort to sustain these exchange rate regimes has required more expansionary monetary policy in those countries than would otherwise have been the case helps identify a substantial source of what market participants describe as very ample liquidity in world markets....

What does this mean for policy?... To the extent that these forces act to put downward pressure on interest rates and upward pressure on other asset prices, they would contribute to more expansionary financial conditions than would otherwise be the case. And, if all else were equal, which of course is unlikely ever to be the case, monetary policy in the affected countries would have to adjust in response; policy would have to act to offset these effects in order to achieve the same impact on the future path of demand and inflation. To do otherwise would run the risk that monetary policy would be too accommodative, pulling resources from the future in a way that would alter the trajectory for the growth of the capital stock, perhaps amplifying the imbalances, and compromising the price stability....

Let me conclude by observing that a constellation of factors has aligned to produce the current combination of low world interest rates, low risk premia and large global imbalances. Most of these factors are outside the control of U.S. monetary policy, and we do not fully understand their implications for our economy and for policy....