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Monetary Policy

.. r to the recent Asian financial turbulence was a significant contributing factor to this crisis.25 Specifically, several key emerging economies in Asia tied their currencies to the dollar, yet maintained significant trading relationships with Japan. Consequently, a significant appreciation of the dollar relative to the yen impelled these countries to follow the dollar (and U.S. monetary policy), thereby causing their currencies to appreciate against the yen. Consequently, their trade positions with Japan were severely effected just before the currency attacks began, thereby significantly contributing to the financial crises in Asia.26 Other Evidence Evidence on the impact of changes in U.S. monetary policy on foreign (international) interest rates recently has emerged from research related to the choice of exchange rate regime literature.

In considering alternative exchange rate regimes available to emerging market countries, for example, Frankel and others have examined the interest rate responses in emerging countries to changes in U.S. (Federal Reserve) interest rates.27 Frankel finds that when the Federal Reserve raises interest rates, these increases are quickly and entirely passed through to those emerging market economies with exchange rates rigidly tied to the dollar. Such exchange rate regimes require the emerging economy to follow the same monetary policy as the U.S. regardless of its appropriateness to local economic conditions. The situation is even more dramatic, Frankel finds, for emerging market economies that maintained a loose link to the dollar (such as Brazil or Mexico).

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In these cases, a Federal Reserve interest rate hike induces local interest rates to increase by more than those in the U.S.; these emerging market rates turn out to be more sensitive to U.S. policy moves and rise by more than one-for-one.28 (Similar results are found by Hausmann et al., and Frankel and Okongwu.) Frankel argues that the reason for this surprising result is that the U.S. interest rate increase has a large negative effect on capital flows and international investors are nervous about the loose exchange rate link, requiring an extra risk premium for devaluation and default risk as well as for the lack of credibility on the part of macroeconomic policymakers. In short, this evidence indicates that changes in U.S. monetary policy can have potent impacts on the interest rates in emerging market economies under different exchange rate regimes.

The evidence suggests that as international financial markets become more integrated, interest rates in emerging economies may become increasingly sensitive to changes in the interest rates of large developed countries. The empirical evidence briefly outlined here indicates that changes in U.S. monetary policy importantly affect financial markets in emerging markets in a number of ways. These changes may dominate capital flows in emerging market economies and U.S. rate hikes have been associated with banking or financial crises in these developing economies. Further, movements in U.S. interest rates may have potent effects on interest rates in emerging markets under differing exchange rate regimes.

Anecdotal Evidence: The Interest Rate Cuts in the Fall of 1998 In addition to this growing collection of formal empirical evidence, anecdotal evidence is also relevant. In particular, assessments of the three Federal Reserve interest rate cuts in the fall of 1998 led several analysts and Fed watchers to conclude that international factors may have weighed heavily in precipitating this Federal Reserve action. These interest rate cuts, it will be remembered, took place in the context of international financial market turbulence associated with the Russian devaluation and debt moratorium in mid-August 1998. It was during this period that the Federal Reserve cut interest rates and took to monitoring risk and liquidity spreads after world financial markets threatened to seize up following the Russian problems. The official rationale for these rate cuts was always framed in terms of their effects on the U.S.

economy. Nevertheless, FOMC minutes indicated the moves were undertaken in light of the effects of the prevailing global (international) turmoil including its impact on the liquidity of financial markets. In assessing the episode, various economists, Fed watchers, and market observers generally concurred with the need for Federal Reserve action. Their interpretations of this action, however, often more explicitly recognized the international dimension of the Federal Reserve policy moves and of the Federal Reserve’s implicit assumption of important international lender-of-last-resort responsibilities (associated with the dollar’s reserve currency status). One well-known market observer, Allen Sinai, for example, argued that: The Greenspan Federal Reserve appears to have shifted regime, operating with a new policy framework that takes the world economy and financial system into account, viewing the U.S.

as one component in this system.30 Another market observer remarked: The Fed Chairman understood that he had to act quickly to convince markets the U.S. central bank was ready to assist the world economy in crisis.31 Similarly, in remarks to the American Economic Association in January 1999, the IMF’s Stanley Fischer stated that: in recent months the leading central banks, in recognition of the feedbacks between the emerging market and the industrialized economies, have taken actions in the interests of their own countries that stabilize the world economy.32 In short, in taking this action, the Federal Reserve indicated it is capable of taking international, global factors into account and, indeed, providing important international lender-of-last-resort services, thereby serving to calm skittish world financial markets in situations of sharp increases in demand for international liquidity.33 This is another manifestation of the international dimensions of Federal Reserve policy, which is sometimes not explicitly recognized. Summary Federal Reserve monetary policy has traditionally focused on the domestic economy. Over time, however, a number of significant trends have underscored the potential importance of the international dimension of contemporary monetary policy. Such trends include the following: Financial markets continue to become increasingly integrated internationally; capital is evermore mobile.

The U.S. dollar continues to remain the world’s principal international (key, reserve, and vehicle) currency despite evolving exchange rate arrangements. Official and unofficial dollarization continues in several emerging market economies. These trends suggest that monetary policy may have differing transmission mechanisms increasingly involving international variables than was earlier the case. In addition to these trends, empirical evidence recently has accumulated showing that changes in U.S. monetary policy can significantly impact emerging market economies in a number of ways.

For example, changes in U.S. monetary policy can (1) dominate capital flows in emerging market economies, (2) be associated with financial crises in these countries, and (3) significantly impact interest rates and financial markets in emerging economies under differing exchange rate arrangements. Furthermore, experience shows that the Federal Reserve can successfully assume international lender-of-last-resort responsibilities and stabilize world financial markets in situations of international liquidity crises. Implications for U.S. Monetary Policy Several important implications for U.S.

monetary policy emerge from these trends and growing empirical evidence. They include the following: Given capital mobility and the practical reality that political pressures will dictate a preference for domestic monetary policy goals, the policy trilemma for the U.S. boils down to flexible exchange rate arrangements and a price stability objective for monetary policy. The Federal Reserve cannot deviate from or lose sight of its price stability goal, and the Federal Reserve should not sacrifice domestic for other goals. Nonetheless, it may be desirable to recognize the significant, increasingly important international repercussions of changes in U.S. monetary policy in order to better achieve these domestic goals. Recognizing these repercussions and their potentially important feedback effects suggest that changes in U.S.

monetary policy may be more potent and wide-ranging than earlier believed. Consequently, to best achieve domestic goals in a nondisruptive manner, the degree or speed of policy moves may need to be adjusted accordingly. If these increasingly important repercussions and their potential feedback effects (e.g. changes in exports, import prices, or capital flows) can be identified, anticipated, and taken into account, their effects potentially may be offset, resulting in smoother transitions for the domestic economy and for financial markets. By taking these effects into account, implementation of policy changes can result in a less volatile, less costly, less disruptive outcome. Policy implementation may be improved. In short, informal inflation targeting by the Federal Reserve may be implemented in a way that recognizes international concerns.

Recognizing these growing international impacts of changes in monetary policy suggests that in order for the Federal Reserve to best achieve its goals, policy changes may need to be undertaken in a well-telegraphed, gradual, deliberate manner so that no policy surprises or unanticipated repercussions occur, disrupting international and domestic markets. In short, to promote stability, the Federal Reserve may be well advised whenever possible to avoid sharp, rapid, and unexpected policy changes. The Federal Reserve should increasingly recognize international LOLR responsibilities and be prepared to respond to international liquidity crises.34 These international factors may best be taken into account by maintaining a stable price environment and carefully, jointly monitoring forward-looking market prices such as various bilateral and broad trade-weighted measures of the dollar exchange rate, commodity prices, and bond yields as policy indicators. These market price indicators may in turn be supplemented by various measures of global prices, world commodity prices, and global bond yields to gain information about prospective global price movements, global price expectations, and world liquidity.35 Dr. Robert E.

Keleher Chief Macroeconomist to the Vice Chairman Endnotes 1. For a discussion of these responsibilities, see Robert E. Keleher, An International Lender of Last Resort, the IMF, and the Federal Reserve, Joint Economic Committee, February 1999. 2. The word integration denotes the bringing together of parts into a whole. The more integrated markets are, the more they behave as a unified whole, rather than segmented parts.

Financial market integration increases the degree of interdependence among financial markets and such integration is alternatively defined as (1) the extent to which markets are connected, (2) the degree of responsiveness and sensitivity to foreign disturbances, or (3) the degree of openness. 3. See, for example, Maurice Obstfeld, The Global Capital Market: Benefactor of Menace?, Journal of Economic Perspectives, Volume 12, Number 4, Fall 1998, pp.9-30; Maurice Obstfeld and Alan M. Taylor, The Great Depression as a Watershed: International Capital Mobility over the Long Run, in The Defining Moment: The Great Depression and the American Economy in the Twentieth Century, Edited by Michael D. Bordo, Claudia Goldin, and Eugene N. White, University of Chicago Press, Chicago, 1998, pp.353-402. 4.

See Barry Eichengreen, Toward A New International Financial Architecture, Institute for International Economics, Washington DC, 1999, pp.2-3. 5. See, for example, Eichengreen, op. cit., p.3 6. Obstfeld, (1998) op. cit., pp.14-5.

7. These might take the form of currency boards or dollarization regimes. 8. Obstfeld, 1998, op. cit., p.18.

9. For an alternative perspective, see Jeffrey Frankel, No Single Currency Regime is Right for All Countries of at All Times, NBER Working Paper 7338, September 1999. 10. Inflation targeting in and of itself does not have to be exclusively inward looking in the U.S., but instead can be implemented in a way that recognizes international concerns (see below). 11.

See, for example, Barry Eichengreen, Globalizing Capital, Princeton University Press, Princeton, 1996, p.195. 12. R.A. Mundell, The Future of the Exchange Rate System, paper prepared for the Rocca di Salimbeni Conference, Monte dei Paschi di Siene, Siena, Italy, November 24, 1994, p.12 (parentheses added). 13. See Ronald McKinnon, Mundell, the Euro, and the World Dollar Standard, paper prepared for presentation at the American Economic Association, January 8, 2000, pp.8-10, and Philipp Hartmann, Currency Competition and Foreign Exchange Markets: The Dollar, the Yen, and the Euro, Cambridge University Press, Cambridge, 1998, pp.

35-39, especially Chapter 2. 14. See Robert E. Keleher, An International Lender of Last Resort, the IMF, and the Federal Reserve Joint Economic Committee, February, 1999. 15. See Kurt Schuler, Basics of Dollarization, JEC Staff Report, July 1999.

16. See, for example, Richard D. Porter and Ruth A. Judson, The Location of U.S. Currency: How much is Abroad? Federal Reserve Bulletin, October 1996, pp.883-903.

17. Guillermo Calvo, Leonard Leiderman, and Carmen Reinhart, Inflows of Capital to Developing Countries in the 1990s, Journal of Economic Perspectives, Volume 10, Number 2, Spring 1996, p. 126. 18. Morris Goldstein and Philip Turner, Banking Crises in Emerging Economies: Origins and Policy Options, B.I.S.

Economic Papers No. 46, October 1996, p. 10. 19. Guillermo Calvo, Leonard Leiderman, and Carmen Reinhart, Capital Inflows and Real Exchange Rate Appreciation in Latin America, IMF Staff Papers, Vol.

40, No. 1, March 1993, pp. 108-151; Michael Dooley, Eduardo Fernandez-Arias, and Kenneth Kletzer, Recent Private Capital Flows to Developing Countries: Is the Debt Crisis History?, NBER Working Paper, No. 4792, July 1994; Punam Chuhan, Stijn Claessens, and Nlandu Mamingi, Equity and Bond Flows to Asia and Latin America: The Role of Global and Country Factors, Policy Research Working Papers, International Economics Department, World Bank, WPS 1160, July 1993; Morris Goldstein, Coping With Too Much of a Good Thing, Policy Research Working Paper 1597, International Economics Department, The World Bank, September 1995; Eduardo Fernandez-Arias, The New Wave of Private Capital Inflows: Push or Pull? Policy Research Working Paper 1312, The World Bank, November 1994.; Barry Eichengreen, Trends and Cycles in Foreign Lending, in Horst Siebert (ed.), Capital Flows in the World Economy, Tubingen; Mohr, 1991, pp. 3-28; Barry Eichengreen and Albert Fishlow, Contending With Capital Flows: What is Different About the 1990s? A Council on Foreign Relations Paper, 1996. 20. Barry Eichengreen and Andrew K.

Rose, Staying Afloat When the Wind Shifts: External Factors and Emerging-Markets Banking Crises, NBER Working Paper 6370, January 1998, pp. 5, 6 (parentheses added). 21. Jeffrey A. Frankel and Andrew K.

Rose, Currency Crashes in Emerging Markets: An Empirical Treatment, Journal of International Economics, 41, Nos. 3/4, November 1996, pp. 351-366. 22. Graciela L.

Kaminsky and Carmen M. Reinhart, The Twin Crises: The Causes of Banking and Balance Payments Problems, International Finance Discussion Papers, Federal Reserve Board, 1996-554, p. 8. 23. Roberto Chang and Andres Velasco, The Asian Liquidity Crisis, NBER Working Paper 6796, November 1998 (quoted from abstract).

24. Changes in the foreign exchange value of the dollar can importantly reflect changes in U.S. monetary policy. 25. See Joseph Whitt, The Role of External Shocks in the Asian Financial Crisis, Economic Review, Federal Reserve Bank of Atlanta, Second Quarter 1999, pp. 18-31, and studies cited therein (p.

24). 26. See also Ronald I. McKinnon, Euroland and East Asia in a Dollar-Based System, The International Economy, September/October 1999, p. 45, 67.

27. See Jeffrey A. Frankel, No Single Currency Regime is Right for All Countries, Testimony before the Subcommittee on Domestic and International Monetary Policy of the Committee on Banking and Financial Services, U.S. House of Representatives, May 21, 1999(a); Jeffrey A. Frankel, No Single Currency Regime is Right for All Countries or at All Times, NBER Working Paper 7338, September 1991(b); Jeffrey A. Frankel and Chudozie Okongwu, Liberalized Portfolio Capital Inflows in Emerging Markets: Sterilization, Expectations, and the Incompleteness of Interest Rate Convergence, International Journal of Finance and Economics, Vol.

1, No. 1, January 1996, pp. 1-23; and Ricardo Hausmann, Michael Gavin, Carmen Pages-Serra, and Ernesto Stein, Financial Turmoil and the Choice of Exchange Rate Regime, Inter-American Development Bank, Office of Chief Economist, Working Paper #400, 1999. The discussion here follows Frankel 1999(a). 28.

See Frankel 1999(a), pp. 7-8; and Frankel 1999 (b), p. 22. 29. See, for example, Minutes of the Federal Open Market Committee, Federal Reserve Bulletin, January 1999, p.

45. 30. Sinai was quoted in Gerald Baker, Man of the Year Alan Greenspan: Guardian Angel of the Financial Markets, Financial Times, December 24, 1998, p. 9. 31. Baker, ibid. 32.

Stanley Fischer, On the Need for an International Lender of Last Resort, paper prepared for delivery at the American Economic Association, New York, January 3, 1999. 33. It should be noted that key market price indicators (i.e., commodity prices, bond yields, and the foreign exchange value of the dollar) were signaling the Federal Reserve to ease at the time and broad measures of price inflation were benign. 34. For a discussion of these responsibilities and ways to implement them, see Keleher op. cit., p. 9.

35. See discussion in Keleher, op. cit., p.9. Return Home Economics Essays.


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