After embarking on a third round of easing last year that only involved extending the length of its zero rate policy and changing the Fed’s Treasury portfolio duration mix, the Fed has recently started QE3 with an even more aggressive tone. It is now targeting the unemployment rate, communicating its commitment to accommodation even after the US economy has picked up. And to do this, it will lengthen asset maturities, buy mortgages, and extend the zero rate policy. This is very aggressive in my view.
Just over a week ago, Federal Reserve Board Chairman Ben Bernanke gave a full-throated defense of the Fed’s continued accommodative monetary policy stance, saying “we recognize that unconventional monetary policies come with possible risks and costs; accordingly, the Federal Reserve has generally employed a high hurdle for using these tools and carefully weighs the costs and benefits of any proposed policy action.” But the Fed Chairman was especially at pains to dispel the belief that Fed policy has created problems outside of the US via changes in private portfolio preferences that see hot money flow into emerging markets, buoying their currencies and depressing their export capabilities.
Although the monetary accommodation we are providing is playing a critical role in supporting the U.S. economy, concerns have been raised about the spillover effects of our policies on our trading partners. In particular, some critics have argued that the Fed’s asset purchases, and accommodative monetary policy more generally, encourage capital flows to emerging market economies. These capital flows are said to cause undesirable currency appreciation, too much liquidity leading to asset bubbles or inflation, or economic disruptions as capital inflows quickly give way to outflows.
I am sympathetic to the challenges faced by many economies in a world of volatile international capital flows. And, to be sure, highly accommodative monetary policies in the United States, as well as in other advanced economies, shift interest rate differentials in favor of emerging markets and thus probably contribute to private capital flows to these markets. I would argue, though, that it is not at all clear that accommodative policies in advanced economies impose net costs on emerging market economies, for several reasons.
First, the linkage between advanced-economy monetary policies and international capital flows is looser than is sometimes asserted. Even in normal times, differences in growth prospects among countries–and the resulting differences in expected returns–are the most important determinant of capital flows. The rebound in emerging market economies from the global financial crisis, even as the advanced economies remained weak, provided still greater encouragement to these flows. Another important determinant of capital flows is the appetite for risk by global investors. Over the past few years, swings in investor sentiment between “risk-on” and “risk-off,” often in response to developments in Europe, have led to corresponding swings in capital flows. All told, recent research, including studies by the International Monetary Fund, does not support the view that advanced-economy monetary policies are the dominant factor behind emerging market capital flows. Consistent with such findings, these flows have diminished in the past couple of years or so, even as monetary policies in advanced economies have continued to ease and longer-term interest rates in those economies have continued to decline.
Second, the effects of capital inflows, whatever their cause, on emerging market economies are not predetermined, but instead depend greatly on the choices made by policymakers in those economies. In some emerging markets, policymakers have chosen to systematically resist currency appreciation as a means of promoting exports and domestic growth. However, the perceived benefits of currency management inevitably come with costs, including reduced monetary independence and the consequent susceptibility to imported inflation. In other words, the perceived advantages of undervaluation and the problem of unwanted capital inflows must be understood as a package–you can’t have one without the other.
Of course, an alternative strategy–one consistent with classical principles of international adjustment–is to refrain from intervening in foreign exchange markets, thereby allowing the currency to rise and helping insulate the financial system from external pressures. Under a flexible exchange-rate regime, a fully independent monetary policy, together with fiscal policy as needed, would be available to help counteract any adverse effects of currency appreciation on growth. The resultant rebalancing from external to domestic demand would not only preserve near-term growth in the emerging market economies while supporting recovery in the advanced economies, it would redound to everyone’s benefit in the long run by putting the global economy on a more stable and sustainable path.
Finally, any costs for emerging market economies of monetary easing in advanced economies should be set against the very real benefits of those policies. The slowing of growth in the emerging market economies this year in large part reflects their decelerating exports to the United States, Europe, and other advanced economies. Therefore, monetary easing that supports the recovery in the advanced economies should stimulate trade and boost growth in emerging market economies as well. In principle, depreciation of the dollar and other advanced-economy currencies could reduce (although not eliminate) the positive effect on trade and growth in emerging markets. However, since mid-2008, in fact, before the intensification of the financial crisis triggered wide swings in the dollar, the real multilateral value of the dollar has changed little, and it has fallen just a bit against the currencies of the emerging market economies. [emphasis added]
This defense is not adequate. Bernanke himself admits that highly accommodative policy by advanced economies shifts interest rate differentials in a way that creates capital flows to emerging markets. But then he waves this off by saying the flows are not that large and that emerging markets should stop manipulating their currencies and just take it because they need the exports. This is complete balderdash. Ceteris paribus, easy money in Europe, Japan and the US is going to be a net negative for emerging markets. And while Bernanke is thought to have meant China when he referenced fx intervention, he could just as easily have meant Brazil.
Well, the Brazilians had had enough of this even before QE3 began. Now Brazilian Prime Minister Guido Mantega has admitted that his country has instituted a “dirty float” in order to stop his currency from swinging wildly as the developed economies manipulate their economies with central bank liquidity. The graph below shows that the dirty float has actually stopped a depreciation in recent months, causing the Real to trade ina narrow range around 2 reals to the US dollar.
I am decidedly against easy money as a policy tool to reflate moribund economies because it creates distortions central banks cannot control. And these distortions are significant domestically and internationally. In my view, what we are now seeing could be the last vestiges of the forty year system of fiat currency, floating exchange rates and free capital flows. The Europeans now have the euro. The Swiss have a currency ceiling that the Swiss National Bank defends aggressively. The Chinese are pegged to the US dollar. And now even the Brazilians are admitting to a dirty float and currency intervention. That is well over half the world’s GDP in a dirty or fixed exchange rate system right there.
It is only a matter of time before we see capital controls start to form. Either developed economies find growth or capital controls are coming as the currency wars become increasingly acrimonious. I do not subscribe to the view that competitive currency devaluations can work in a benign way. They lead to more intervention and greater friction. The IMF is the only major policy voice warning us of this. It is a warning we should heed.