Sunday, September 30, 2007

Mishkin on Globalization and Rebalancing via Exchange Rates

Frederic Mishkin's gave a speech last Thursday on "Globalization, Macroeconomic Performance, and Monetary Policy," in which he talks in turn about how globalization effects inflation, output, and the "monetary transmission mechanism" (MTM; i.e. how the fed speeds up or slows down the economy). While his views on the first two topics are straightforward and unsurprising, what he says about the MTM is very very interesting.

On Inflation:

We should never forget Milton Friedman's adage that "inflation is always and everywhere a monetary phenomenon." In the long run, as long as a central bank has an independent monetary policy--that is, it is not locked into a fixed-exchange-rate regime in which its hands are tied--the rate of inflation is determined by monetary policy. ... many of the exaggerated claims that globalization has been an important factor in lowering inflation in recent years just do not hold up.

On Output:
[E]conomic globalization has the potential to be stabilizing ... The bottom line, however, is that it is not at all clear whether globalization increases or reduces output volatility.

On the Monetary Transmission Mechanism (MTM):
One of the key transmission channels of monetary policy is the exchange rate. A tightening of monetary policy, for example, raises U.S. interest rates relative to those abroad, thereby inducing upward pressure on the foreign exchange value of the dollar. An appreciation of the dollar, in turn, restrains exports (because the price of U.S. goods rises when measured in foreign currencies) and stimulates imports (because imports become cheaper in dollar terms). The resulting decrease in net exports implies a reduction in aggregate demand. In addition, an appreciation of the dollar that leads to a decline in import prices also helps restrain overall U.S. inflation.

By expanding the share of tradable goods and services in the economy, globalization might increase the role of the exchange rate as a transmission channel of monetary policy and could reduce the role of the interest rate channel. The larger the share of imports and exports in the economy, the greater the change in net exports--and, hence, in the contribution of net exports to gross domestic product (GDP) growth--for a given change in the exchange rate. In addition, the larger the share of imports in the economy, the larger should be the effect on overall CPI inflation of a given change in import prices when the exchange rate changes. (This effect is explicitly incorporated in Federal Reserve staff models of U.S. inflation, which weight import prices by the share of imports in the consumption basket.)

By the same token, the effect of the interest rate channel on overall economic activity may be diminished by greater trade integration as changes in domestic demand are offset by induced changes in imports. Guerrieri, Gust, and López-Salido (2007), for example, find that shocks to domestic demand move output less in more-open economies because they lead to larger offsetting movements in the trade balance. Supporting this result, Ihrig and others (2007) conclude that correlations between real GDP growth and real domestic demand growth have declined in recent decades in the United States and several other industrial economies.

In addition to increasing the sensitivity of the economy to changes in exchange rates, globalization may have increased the sensitivity of exchange rates to monetary policy. Over the past few decades, as capital controls have been eliminated in most major economies and the levels of home bias in portfolio investment have declined, financial markets around the world have become more tightly integrated. An implication of this financial globalization is that demand for domestic and foreign assets is likely to have become more sensitive to international differences in perceived rates of return. Accordingly, monetary policy actions may now exert more influence on exchange rates than was the case when markets were less tightly integrated and assets of different countries were perceived to be less substitutable for each other. This linkage between globalization and the effect of monetary policy on exchange rates is somewhat speculative but represents a worthwhile avenue for further research.
Now why is this so interesting? It is, after all, a fairly text-book treatment of how interest rates effect exchange rates. First, Fed speakers don't usually talk much about exchange rates, and when they do it's usually in the context of import price inflation. This speech is different. Mishkin downplays the potential for increases in import prices to be an independent source of inflation, distinct from monetary stimulus. Instead he emphasizes how exchange rate changes can affect economic growth.

This sounds like an acknowledgement and tacit endorsement that significant dollar depreciation is likely to be one of the main channels through which interest rate cuts, if needed, can effectively stimulate the economy.

Here's the thinking. Suppose the housing recession deepens, and housing prices continue to fall. Suppose also that this leads to a decline in consumer spending (which is 70% of GDP), as households respond by saving more and spending less. This is the standard scenario of the "recession is imminent" crowd. To keep the economy at full employment, the Fed has to get someone to pick up the slack. They do this by cutting interest rates until a sufficient number of people and businesses, either in the U.S. or abroad, decide they want to buy more American goods and services. The only question is, of the many ways that lower interest rates can stimulate that spending, which will be the path of least resistance. The usual housing mechanism (extra mortgage lending leading to extra housing construction) is clearly not going work this time. But getting foreigners to buy more via dollar depreciation will work, as long as that depreciation is allowed to happen. Perhaps this speech is a signal that the Fed is laying the groundwork for that possibility. It's perhaps no coincidence that Mishkin's next speech is on Systemic Risk, which would help to lay even more of that groundwork.

This is going to be an interesting one to watch play out.

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