Monetary policy: from independence to interdependence

22 May 2013, Congress of the United States of America, Washington DC. Ben Bernanke, at that time Fed Chairman, suggested he might start reversing the accommodative stance of monetary policy might in the near future thanks to the good performance of the US economy. In the ensuing weeks, his statements led to violent movements in global markets and especially in the emerging economies, which saw their currencies depreciate considerably, as well as suffering higher risk premia, stock market losses and a reduction in capital inflows. This episode, known as the «taper tantrum», illustrates how the effects of the monetary policy of one of the largest financial centres in the world are felt far beyond its own national borders. But why should Bernanke’s domestic decision affect the rest of the world’s economies? And through which mechanisms do the words of the Fed Chairman impact the economies in the rest of the world?

Traditionally trade has been the main channel for transmitting monetary policy between countries. On the one hand, when a central bank such as the Fed lowers its benchmark interest rate, the currency, in this case the dollar, tends to depreciate, making imports from the rest of the world more expensive and thereby weakening demand.1 On the other hand, monetary accommodation stimulates domestic demand in the US, thereby boosting demand for these imports. Although this second effect takes longer to appear, historically it has been stronger than the first and, consequently, the net commercial effect on the rest of the world has been positive.2 However, under the current circumstances there are reasons to assume that aggregate demand is less sensitive to monetary stimuli so that positive net effects are no longer guaranteed: specifically, the heavy borrowing of advanced economies makes it difficult for monetary policy to result in higher demand for foreign imports (since those agents with higher levels of debt tend to increase their consumption less).

But it is not only the situational factors related to the commercial channel that are jeopardising the positive trend in monetary policy externalities. In fact, as seen in the first graph, since the 1980s there has been extensive financial globalisation with an increase in international capital flows and higher gross external borrowing by economies. As it creates an international market for investment and savings, financial globalisation offers an external source of financing at an international interest rate which is nevertheless influenced by the world’s major financial centres such as the US due to their relative importance for the world economy.3 International capital flows have therefore become an important channel for transmitting monetary policy. For example, a drop in the US interest rate results in heavier capital flows towards those foreign economies with the highest returns, whose monetary authorities therefore face two choices: tolerate the substantial appreciation in their currency to reduce the inflow of capital or limit exchange rate fluctuations and accept heavy capital inflows. Moreover, both alternatives entail additional negative consequences: while strong appreciation in a currency damages exports and can lead to deflationary pressure (as it brings down the cost of imports), capital inflows can relax credit conditions more than is desirable and therefore increase the risk of financial instability. As we will see, one way of reducing both the appreciation of a currency and heavy capital inflows consists of adjusting the domestic interest rate by imitating the foreign monetary policy: by offering similar yields, abrupt movements in capital and exchange rate pressure are avoided but, in exchange, authorities lose control of their monetary policy.

Although financial globalisation is no recent phenomenon, given the current situation there is an additional factor that increases its impact on the externalities of monetary policy. In the last few years the main central banks of the advanced economies (the Fed, ECB, Bank of England and Bank of Japan) have relaxed their monetary policies to unprecedented levels in order to boost the recovery in domestic demand after the financial crisis. As their benchmark rates are close to 0%, they have also implemented unconventional measures that have resulted in a significant injection of liquidity (see the second graph). With some advanced economies in a low-yield environment, this ample liquidity has flowed towards other neighbouring economies. With the aim of avoiding sharp appreciations in their currencies and minimising the disruption of capital inflows, the economies receiving this liquidity have also opted to relax their monetary conditions, setting lower interest rates than warranted by their domestic needs. Although, in the short term, the activity of these economies benefits from such favourable financial conditions, the situation is not appropriate for the economy’s domestic requirements, thereby increasing the risk of financial instability, and the effects over the medium to long term can be negative, as happened with the real estate bubble that fuelled the previous phase of growth in some advanced economies. Moreover, as explained in the article «Bank globalisation and the international transmission of monetary policy» in this Dossier, the system of global banks that channels some of these capital flows, through which a parent bank obtains resources in advanced economies, benefitting from easier credit conditions, and then distributes these resources to branches or local entities in the emerging economies, creates a source of systemic risk. However, central banks argue that their measures have been crucial for the recovery of economies and that economic externalities would be much more negative if the US had more anaemic growth or the euro area’s economy were still at a standstill.

So the externalities of more accommodative monetary policy in the world’s major financial centres are transmitted via a traditional commercial channel and a financial channel that passes on the easy financial conditions to the rest of the world. But what is the relative importance of all this? According to the Fed’s estimates,4 in response to measures that reduce the 10-year interest rate for US debt by 25 bps: (i) the dollar’s depreciation pushes down the GDP of the rest of world by 0.05%, (ii) US domestic demand increases by 0.5%, it boosts imports and pushes up the GDP of the rest of the world by 0.05%, and (iii) foreign interest rates fall by 10 bps, increasing the GDP of the rest of the world by 0.25%. So, according to the Fed’s estimates, the commercial channel would currently have a zero net effect. Consequently, externalities would only be visible through the financial channel which, although it has a positive effect in the short term, introduces financial instability over the medium to long term.

In conclusion, the dominant role taken on by monetary policy as a means of stimulating advanced economies has revived debate about its international externalities. At present the financial links between economies have been strengthened to the extent that capital flows and risky assets have significant global determining factors. In practice this means a loss of capacity to implement independent monetary policies,5 so it is therefore essential to review the opportunities for cooperation and coordination within the international monetary system, something which is examined in the article «Policies to coordinate the monetary and financial system» in this Dossier. Another alternative to lessen such externalities is for fiscal policy and structural reforms to help boost the economy and complement monetary policy to a greater extent.

Adrià Morron Salmeron

Macroeconomics Unit, Strategic Planning and Research Department, CaixaBank

1. This effect has led to the coining of the term «currency war» to describe situations in which central banks implement accommodative policies to depreciate the currency and boost the competitiveness of exports.

2. See the speech by Rajan on 12 March 2016 in New Delhi, «Towards rules of the monetary game», and Blanchard (2016), «Currency wars, coordination, and capital controls», NBER Working Paper. However, as pointed out by Blanchard, this effect also depends on each country’s characteristics, such as the share of its exports to the US or how sensitive its economy is to commodity prices.

3. Another important factor that explains the influence of the US is the use of the US dollar as a medium of exchange around the world and as a source of bank funding. See the article «Bank globalisation and the international transmission of monetary policy», in this Dossier.

4. John Ammer, Michiel De Pooter, Christopher Erceg and Steven Kamin, 2016, «International Spillovers of Monetary Policy», Federal Reserve Board of Governors International Finance Discussion Papers Note.

5. Hélène Rey (2015), «Dilemma not trilemma: the global financial cycle and monetary policy Independence», NBER Working Paper.