from Follow the Money

Does the Fed’s mandate now extend to Beijing, Moscow and Riyahd?

June 27, 2008

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The Financial Times, in a leader, says yes.

If there were a Central Bank of the World its monetary policy committee would glance at today’s inflation rates and expectations of future inflation and then raise interest rates. There is no such bank, but there is something close: the US Federal Reserve, the monetary policy of which is mirrored by many countries in the Middle East and Asia. The Fed may not want that responsibility, but it would be wise to worry because, like it or not, low Fed interest rates are contributing to global inflation.

The Fed itself would -- I suspect -- argue that it has to worry about a fall in the dollar, a rise in commodity prices or a fall in the dollar that spurs a rise in commodity prices only to the extent that such developments risk prompting a rise in US inflation, and thus affect the Fed’s ability to guide the US economy. That is a formulation that doesn’t generate any conflict between the Fed’s domestic mandate and the dollar’s global role. The Fed only should care about the dollar’s external value to the extent it influences the Fed’s ability to meet its domestic objectives.

The FT leader goes much further. It argues that dollar pegs generates such large benefits to the US -- namely cheap financing -- that the US should be willing to adopt a monetary policy that is right for the entire dollar zone even if it is wrong for the US. The FT:

The Fed has another reason to worry as well. The greater the inflationary pressure, and the more Asian countries are forced to raise interest rates, the greater the risk that they dump their pegs to the dollar. The results for the US would be unpleasant: a currency crash and even higher domestic inflation. The US benefits from the dollar’s use as a reserve currency; the price is that the Fed cannot forget the effects of its policy on the wider world.

The Fed’s Vice-ChairDon Kohn seems to disagree. He argues, more or less, that if US monetary policy isn’t right for fast growing economies in the emerging world, they should importing US monetary policy. Dollar pegs -- not US rates -- should change. That at least is what Krishna Guha of the FT inferred from Kohn’s speech:

[Kohn] appeared to call on fast-growing emerging markets to drop their exchange rate pegs to the dollar and adopt independent monetary policies – so they no longer import Fed monetary policy. Mr Kohn said “in those countries where strong commodity demands are associated with rapid growth in aggregate demand that outstrips potential supply, actions to contain inflation by restraining aggregate demand would contribute to global price stability”.

The Fed vice-chairman did not specify what steps he thought should be taken to restrain demand in these overheating countries. However, he said economies “benefit from having independent monetary policies that provide room to respond flexibly” to different economic shocks. He added “these benefits could be increased if exchange rate flexibility were to become more widespread”.

These remarks reflect Fed frustration at the way in which fixed exchange rate regimes transmit low interest rates meant to address US economic weakness to rapidly growing emerging economies – fuelling demand for commodities.

Mr Kohn’s speech suggests that the Fed believes that the global economic system would function better if these emerging economies had a greater degree of monetary independence, allowing them to set the interest rates appropriate for their own economies.

The battle lines here are increasingly clear: some argue that the US needs to adjust, by changing its monetary policy to help out countries pegging to the dollar, others argue the rest of the world needs to adjust by letting their currencies appreciate. The US is calling for other countries to have more monetary policy autonomy, and others are calling for the US to, in effect, have a bit less.

Is the FT leader right? Should the dollar be managed as the world’s currency not the United States’ currency? Does the US derive such large benefits from the dollar’s global role that it should adjust its monetary policy -- at a potential cost to the US economy -- in order to make it easier for other countries to peg to the dollar?

I would say no. I have long criticized a global monetary and financial system where dollar-reserve growth in the emerging world sustains large US deficits. Over time, the US -- and the world -- would be better off if Asia and the oil-exporting economies let their currencies float against both the dollar and the euro rather than pegging to the dollar (or managing their currencies against the dollar).

Dollar pegs have created a set of fundamental problems for the world economy.

First, dollar pegs have linked the currencies of the regions of the world with the largest current account surpluses to the currency of the world’s largest deficit country. That creates a set of underlying tensions that have contributed to the recent surge in inflation in many emerging economies. The dollar needs to depreciate in real terms to help bring the US deficit down. The currencies of the surplus countries, by contrast, need to appreciate in real terms. Yet so long as the currencies of regions with different fundamentals are tied together, the only way this adjustment can happen is if prices in the US fall faster than prices in the rest of the dollar zone, or if prices in the surplus countries rise faster than in the US. Current high levels of inflation in the big surplus countries* can thus be viewed as a natural product of their own choice to maintain currencies linked to the dollar -- combined with the United States aversion to deflation.

Second, the large amounts of financing the US now receives from countries that are managing their currencies against the dollar is a mixed blessing. It has helped some parts of the US economy, but hurt others. Large reserve inflows from 2002 to 2006 likely contributed to the excesses in the housing market that are now causing the world so much trouble. And it has had costs as well as the benefit to those countries that have managed their currencies against the dollar: their export sectors have been helped, but they have also sunk a large share of their national wealth into depreciating dollar-denominated assets.

Here it is important to note that both costs and benefits of the dollar’s role as a global reserve currency have been dramatically magnified in recent years. In the 1990s, emerging market central banks typically added somewhere between $100 and $200b to their foreign exchange reserves in a non-crisis year -- and somewhat less to their dollar reserves. That reserve growth was generally financed by capital inflows from the advanced economies. Basically, capital inflows from the advanced economies financed both reserve growth and the emerging world’s aggregate current account deficit.

That kind of world that is consistent with a small US current account deficit, or even a small surplus. It also is a world where the dollar’s status as a reserve currency generates modest but important benefits to the US (the US effectively finances its investment abroad with low-yielding debt placed with central banks).

It, however, is no longer accurately describes the world. Emerging market reserve growth is now far larger -- it topped $1 trillion dollars in 2007, according to the IMF’s data. It looks set to top $1 trillion in 2008 as well. China alone is on track to add close to $1 trillion to its foreign assets this year. The oil exporters won’t be far behind.

The current level of reserve growth reflects both the emerging world’s large current account surplus and net private capital inflows to the emerging world. With Japan also running a small surplus (which is now falling slightly), a world where emerging Asia and the oil-exports both have large surpluses necessarily requires large deficits in either the US or Europe. It is also a world where those deficits will be financed in large part by the sale of American and European financial assets -- stocks (or companies) if not bonds -- to the governments of the emerging world.

And it is a world that doesn’t strike me as being in the long-term interest of either the US or the emerging world.

It isn’t clear that there is a political consensus in China to lose money lending to the US rather than say investing more in Chinese public schools, but that in effect is what the China’s policy of managing its currency against the dollar now requires. At least if China wants to limit inflationary pressures. It isn’t clear that the residents of the Gulf would support the kind of financing the Gulf now provides the US if they had any say in the matter. The lack of domesitc support for the Gulf’s financing of the US is one reason why some think the US shouldn’t press too hard on transparency.

And I would guess that there isn’t political consensus in the US to finance $750 billion current account deficits by selling $750 billion of US equity to the governments of the emerging world. Yet that is what is implied if emerging market governments decide to shift all their foreign asset growth to sovereign funds and state firms in order to try to get better returns.

I have little doubt that emerging market governments have bought something close to $750 billion in US bonds over the past year -- far more than shows up in the (inaccurate) US TIC data. Actually, that needs to be amended to say added $750 billion to their dollar holdings, with the money split between bank accounts and bonds. For the sake of comparison, total sales of US stocks to foreign investors of all kinds in 2007 were only around $200b. $30 billion or so was sold to official investors according to the US data, but the US data understates true purchases by sovereign funds. The real number is at least twice that. But it is still a far cry from the kind of sales that would be required if the sale of US stock and US companies to emerging market governments become the dominant way of financing the US deficit.

The subprime crisis has led to an intensification of US reliance on emerging market governments for financing. The costs of this are now becoming clear. Emerging market reserve growth now seems to have exceeded the emerging world’s capacity to sterilize, contributing not just to high levels of inflation in the emerging world but global inflation.

It is true, as Tim Duy notes, that emerging market reserve growth allowed the US to cut rates and implement a fiscal stimulus without having too worry too much about how the large ongoing US external deficit was going to be financed. But the existing equilibrium isn’t one that anyone should hope lasts for too long. The challenge, in my view, is how to bring the world back toward a true equilibrium -- one that requires less government intervention in the foreign exchange market -- over time.

As often is the case, Martin Wolf’s suggestions are a good place to start.

*Some emerging economies with current account deficits also have high levels of inflation, notably some emerging Asian economies that have been hit hard by the recent rise in food and oil prices.

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