1
Six Observations on Global AdjustmentPanel
Discussion at the Bank of Spains 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
Observations 1 and 2 on the expansion of the
global portfolio.

• 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?

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 Blinders 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.

19
(No Transcript)