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Policy Hub: Macroblog provides concise commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues for a broad audience.

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May 27, 2021

The Role of Central Banks in Fostering Economic and Financial Resiliency

The Atlanta Fed recently hosted its 25th annual Financial Markets Conference, with the theme of Fostering a Resilient Economy and Financial System: The Role of Central Banks. The conference addressed both the adequacy of the monetary policy toolkit and the role of the U.S. dollar (USD) in international financial markets. The conference included two keynote talks. The first day featured a keynote speech by Federal Reserve Board vice chair Richard Clarida, followed by a discussion with Atlanta Fed president Raphael Bostic. The second day began with an armchair discussion featuring Harvard professor Larry Summers and Atlanta Fed research director David Altig. A video of the conference is available here video fileOff-site link. This post reviews some of the highlights from the conference.

Keynote talks
Vice chair Clarida's keynote speechOff-site link focused on global factors that help determine the yield curve for sovereign bonds. Clarida observed that studies of domestic and major foreign government markets have found that most of the movements in the term structure of interest rates can be explained by the overall level of the curve and the slope of the curve. He then reviewed work suggesting that a global factor—one that is highly correlated with estimates of the neutral real interest rate—has a great influence on the level of the curve. Given this information, central banks may not have much ability to influence the yield curve's level unless they are willing to unanchor inflation expectations in their domestic market. Clarida then presented evidence that the slope of the U.S. yield curve is highly correlated with its monetary policy, specifically the deviation of the U.S. neutral nominal policy rate from the actual federal funds rate. He acknowledged that correlation does not equal causation but provided some evidence that central bank decisions (by the Fed and major foreign central banks) have a causal relationship with the slope of the yield curve. These observations led Clarida to conclude that "major central banks can be thought of as calibrating and conducting the transmission of policy...primarily through the slopes of their yield curves and much less so via their levels."

Professor Summers raised a variety of concerns about current policy and the risks to the financial system in his chat on the conference's second day. One of these concerns relates to the monetary policy projections, which suggest that inflation will remain sufficiently low so that the Fed's policy rate may not increase for several years. This expectation of low rates may create a "dangerous complacency," according to Summers, that will make it more difficult to raise rates. The result may be that nominal policy rates remain too low, producing higher inflation that leads to even lower real rates and even higher inflation. The result could be not only a "substantial pro-cyclical bias in financial conditions" but also a threat to financial stability if the low nominal rates result in excessive financial leverage.

Monetary policy panel session
The monetary policy toolkit received some scrutiny in a panel titled "Is the Monetary Policy Toolkit Adequate to Meet Future Challenges?" It was moderated by Julia Coronado, president of MacroPolicy Perspectives. Coronado promised a session with some provocative comments, and each of her panelists delivered. Among the problems addressed by the panelists was central banks' limited ability to counteract economic downturns. Historically, central banks have lowered their nominal interest rate target by several percentage points in response to the onset of a recession, or even the elevated risk of one. The continuing decline in nominal rates, however, has reduced central banks' ability to use rate reductions to fight recessions, instead forcing them to rely more on quantitative easing (or more accurately, large-scale asset purchases). Joseph Gagnon, a senior fellow at the Peterson Institute for International Economics, and Willem Buiter, a visiting professor at Columbia University, provided two alternative ways of restoring the central bank's ability to lower nominal rates by more than 1 or 2 percentage points.

Gagnon's analysis was based on the Fisher equation, in which the nominal interest rate is approximately equal to the real rate of interest plus the rate of inflation. Gagnon observed that central banks, including the Fed, had set a target inflation rate of 2 percent back when the equilibrium real rate was higher (likely around 2 to 3 percent). Establishing this target rate resulted in equilibrium nominal interest rates around 4 to 5 percent, which gave central banks considerable room to respond to a recession. However, in the period since the inflation targets were set, equilibrium real rates have fallen by 1 to 2 percentage points. This decline greatly reduced central banks' ability to lower rates without taking them negative. Thus, to restore the ability of central banks to respond to higher inflation, Gagnon argued that central banks' inflation target should be increased to 3 to 4 percent.

Buiter implicitly started from the same point: that the decline in the equilibrium real rate had left central banks with too little room to cut interest rates. However, rather than raising the inflation target, Buiter argued that a better solution would be to accept deeply negative nominal interest rates. Several central banks in Europe, as well as the Bank of Japan, have lowered their rates below zero but never as much as 1 percent below zero. Buiter recommended that central banks take the steps necessary to be able to have deeply negative interest rates if that is appropriate for conditions.

Simon Potter, vice chairman at Millennium Management, noted an international dimension to the Fed's policy setting. Potter observed that many emerging markets had taken on considerably more debt to respond to the ongoing pandemic. He argued that these countries would need fast U.S. growth, and the accompanying increase in exports to the United States to be able to service their debt. Absent such increased debt service capacity, he pointed out that changes in the structure of these countries' debt markets would make rescheduling their debts even more difficult than it had been previously.

These provocative comments did not go unchallenged, however, as the other panelists raised concerns about the feasibility and/or desirability about each of these policy recommendations in the subsequent discussion that Coronado moderated.

Global dollar policy session
A panel on the conference's second day had the provocative title "Is the Financial System's Backbone, the U.S. Dollar, Also a Transmitter of Stress?" The panel's moderator was Federal Reserve Bank of Dallas president Robert Kaplan, who began the discussion by highlighting the importance of the USD in both international trade and international financial markets.

Stanford University Professor Arvind Krishnamurthy's presentation Adobe PDF file format supplied further evidence on the importance of the USD in trade and financial markets. He suggested that the USD's important role resulted in it providing a convenience yield to its users, which resulted in lower USD interest rates for those borrowing USD—both domestic and foreign borrowers. These lower rates, however, came with some financial risks, according to Krishnamurthy. For one, lower rates may induce greater financial leverage in U.S. borrowers. Additionally, foreigners who borrow USD to take advantage of the lower rates may be creating a mismatch between the currency they receive as revenue (especially from sales in their domestic markets) and the USD they need to repay their debt.

Thomas Jordan, chairman of the governing board of the Swiss National Bank, also noted the dominance of the USD in international markets and discussed its implications from the Swiss point of view. He noted two ways in which Switzerland is especially vulnerable to developments regarding USD. First, Swiss banks hold substantial amounts of USD assets and liabilities. Second, the Swiss franc is a safe haven currency that experiences increased demand in times of international financial stress. These result in Switzerland having a strong interest in global financial stability and especially in the stability of USD-funding markets. In this respect, Jordan observed that the Federal Reserve's swap lines with other central banks, including the Swiss National Bank, has been "very crucial." The swap lines provide an important liquidity backstop that recently proved valuable during the COVID-19 crisis.

Michael Howell, the managing director at CrossBorder Capital, focused on the potential for another currency to displace the USD in international markets. In his presentation Adobe PDF file format, he argued we should not be "shortsighted" in dismissing other currencies. In particular, he pointed to China, saying that China sees the USD as a rival and wants to displace it, particularly in Asia. He then went on to discuss some of the steps that China would need to take—and is taking—to displace the USD.

After these remarks by the panelists, Kaplan moderated a question-and-answer session that took a closer look at these and other issues.