Global Imbalances and Monetary Policy Implications

1. “Six Observations on Global Adjustment”Panel Discussion at the Bank of Spain’s Conference on Central Banks in the 21st Century Vincent Reinhart Director, Division of Monetary Affairs Board of Governors of the Federal Reserve System 9 June, 2006

2. The usual disclaimer The views expressed are my own and are not necessarily shared by anyone else in the Federal Reserve System.

3. The scale of the imbalances is enormous. Source: IMF World Economic Outlook, April 2006

4. Plan • Present a very simple framework that is useful in understanding global imbalances; • Draw six observations from that framework; and • Discuss monetary policy implications in closing.

5. When I said simple, I meant it. Pus/Pf Exports Imports Exports, Imports

6. Within this framework, there are five key margins influencing an external imbalance. • The relative price of traded goods and services produced at home versus those produce abroad; • The relative price of traded goods and services produced at home versus nontraded ones; • Home versus foreign income; • Home versus foreign wealth; and • The dollar share of the foreign portfolio.

7. The dollar share of the global portfolio may expand over time because • Global economic growth has tilted to a region underdiversified in dollar assets (Dooley, Folkerts-Landau, and Garber); or, • Financial globalization has been reducing home bias over time (Greenspan).

8. Observation 1: Bretton Woods I was less stable than commonly believed Reinhart & Rogoff Globalization may have reduced the scope for such safety-valves, putting more pressure on the spot exchange rate. Observation 2: It is the relative change in home bias that matters for the net dollar share in the global portfolio. Why would financial globalization be acting unequally on U.S. and foreign investors? Is there a role for a collateral-based approach to asset demands? Observations 1 and 2 on the expansion of the global portfolio.

9. Observation 3: An important role for assets in shaping behavior may have an ambiguous effect on the nature of the adjustment of imbalances. • There has been a recent recognition on the effect of exchange rate changes on the value of the gross portfolio • Both U.S. and foreign investors hold dollar denominated obligations, so that • Dollar depreciation lowers net U.S. debt • But U.S. net debt is also foreign wealth • And if wealth and income effects are important in determining import demand, there is an offsetting drag to any direct benefit of lower indebtedness.

10. Observation 4: The two key relative price margins may be related in the presence of biased technological growth. Faster productivity growth in manufacturing keeps traded goods competitive with those from abroad. But it also makes nontraded goods relatively more expensive. Source: IMF World Economic Outlook, April 2007

11. Observation 5: Two key external margins may be related. • A depreciation of the dollar that lowers the relative price of U.S. to foreign goods should encourage U.S. exports and discourage imports to the U.S. • For our trading partners, this represents an adverse aggregate demand shock. • If policymakers abroad are not willing to offset this adverse aggregate demand shock, their relative income growth will suffer to the detriment of the global demand for U.S. goods.

12. Observation 6: Meaningful progress in reducing the U.S. external imbalance cannot rely on changes at a single margin. • Some combination of • Relatively faster growth of income and wealth abroad and • Technical progress biased toward nontraded goods at home • Would likely create the market backdrop in which U.S. traded goods become more competitive. • To the extent that this process were gradual, resources could shift efficiently to take the fullest advantage of these changed circumstances • Potentially lessening the magnitude of the overall adjustment.

13. As to monetary policy… • How should policy respond to a gradual adjustment process? • Can monetary policy initiate the adjustment process? • How should policy respond to a sharp adjustment process and potential associated market strains?

14. How should policy respond to a gradual adjustment process? • Changes in theses margins during a phase of gradual adjustment are relative shifts in prices, income, and wealth. • As long as inflation expectations remain contained, • relatively faster growth of the prices of imported goods for a time would be associated with a temporary bulge in overall inflation but would leave no significant imprint on core inflation. • In that case, maintaining the full utilization of resources will both facilitate the movement of resources needed to meet new, relatively higher foreign demands while fostering price stability. • To the extent that inflation expectations and core inflation were not impervious to more rapid core price inflation, • the experience of the past few decades suggests it is important to draw a firm line at preventing inflation from picking up on a permanent basis.

15. Asset prices and monetary policy • The price of an asset, x, matters for policymakers to the extent that it influences the outlook for • Aggregate demand and • Inflation • Policymakers should respond systematically to that extent. • To respond beyond that • Presumes a better understanding of asset prices than the market, • Risks the pursuit of the macroeconomic objectives, and • Could fail because the link between asset prices and the policy instrument is indistinct. • Policymakers concerned about systemic strains should tackle the problem directly by strengthening financial regulation.

16. Can monetary policy initiate the adjustment process? The conventional recommendation is that easier policy at home and tighter policy abroad will depreciate the home currency and make home-produced goods more attractive. Exports Imports Pus/Pf But remember Alan Blinder’s admonition we know the least about exchange rate determination and that pass-through seems to have declined around the world. Exports, Imports

17. The effects on the scale variables may offset the effects of the relative price changes. Looser policy at home and tighter policy abroad should lead to wealth and income changes that encourage imports and discourage exports. Exports Pus/Pf Imports And if coordinated sterilized intervention was employed to try to get the process of weakening the currency started, subsequent monetary policy actions to stabilize the domestic economy would reverse some of those effects. Exports, Imports

18. How should policy respond to a sharp adjustment and potential associated market strains? • It is unhelpful to speculate about low-probability events; in part because • Each episode is different.