We recently invited four international economists to the Federal Reserve Bank of Cleveland to discuss global developments and to help us identify and understand the key international risks that these developments present for U.S. monetary policy. This Commentary develops a key macroeconomic concern that emerged from our conversations.Monetary policy ; Globalization

Owen F. Humpage

English

Research Papers in Economics

Global Risks to U.S. Monetary Policy
by Owen F. Humpage
May 15, 2007
ISSN 0428-1276
Congress has given the Federal 
Reserve System a dual policy man-
date: maintain price stability and pro-
mote maximum sustainable economic 
growth. The Federal Open Market 
Committee interprets its charge solely 
in terms of inﬂ  ation and economic 
growth within the United States, but its 
members understand that global events 
can easily interfere with the System’s 
ability to achieve its domestic objec-
tives. Consequently, they continuously 
watch international developments and 
assess the risks that these changes pose 
to the attainment of their dual mandate. 
As part of this assessment process, the 
Federal Reserve Bank of Cleveland 
recently invited four experts to discuss 
global developments and to help us 
identify and understand the risks that 
these developments present for U.S. 
monetary policy. Our experts were 
Kathryn Dominguez from the 
University of Michigan, Charles Engel 
from the University of Wisconsin, 
Kenneth Kuttner from Oberlin College, 
and Brad Setser from Roubini Global 
Economics. Our discussions were broad 
in scope, ranging from trade issues to 
ﬁ  nancial market regulations. This Eco-
nomic Commentary develops a key 
macroeconomic concern that emerged 
from our conversations. Instead of 
attempting to attribute speciﬁ  c points 
to individuals, this article reﬂ  ects the 
collection of viewpoints that they 
expressed. Arguably, their perspectives 
encompass the opinions of most econo-
mists on the issues discussed here. 
  The Biggest Risk 
According to our panel, the biggest 
international risk to U.S. monetary 
policy is the prospect of a “hard-
landing” adjustment to global imbal-
ances, one consisting of a rapid, 
broad-based depreciation of the dol-
lar and a rise in domestic real inter-
est rates. The adjustment process—
depending on how rapidly it might 
unfold—could easily complicate mon-
etary policy. This would be especially 
true if it occurred when the System 
needed to ease monetary policy in the 
face of softening domestic demand 
and if the central banks of other major 
developed countries were simultane-
ously tightening their monetary poli-
cies; under these two circumstances, 
domestic policy might actually acceler-
ate the adjustment process and harden 
the landing. 
The key characteristic of global imbal-
ance is persistent U.S. current account 
deﬁ  cits. Since 1982, the United States 
has experienced a deﬁ  cit every year 
but one, primarily because we import 
more goods and services than we 
export (see ﬁ  gure 1). Last year, the 
U.S. current account deﬁ  cit reached a 
record $811.5 billion, or 6.1 percent of 
GDP, and most observers anticipate lit-
tle if any sustained improvement in the 
foreseeable future. 
The United States pays for its deﬁ  cits 
by issuing ﬁ  nancial claims, such as 
corporate stocks and bonds, govern-
ment securities, and bank accounts, to 
the rest of the world. As a consequence 
of our persistent deﬁ  cits, the world 
now holds approximately $3.5 trillion 
in net ﬁ  nancial claims on this country 
(see ﬁ  gure 2). Because they essentially 
are entitlements to future U.S. output, 
we often gage our ability to service 
these ﬁ  nancial claims by expressing 
them as a percentage of GDP. Last 
year, the world’s net ﬁ  nancial claims 
against the United States equaled a 
record 26.5 percent of GDP. 
Most economists insist that these 
ﬁ  nancial claims cannot rise indeﬁ  nitely 
relative to our ability to pay. At some 
point, the world’s savers will become 
increasingly reluctant to add dollar-
denominated assets to their portfolios 
without receiving a premium for the 
growing risks associated with doing so. 
Some may even begin to diversify out 
of dollar-denominated assets. When this 
happens, the dollar will depreciate in 
the foreign exchange market and U.S. 
real interest rates will rise. 
Economists disagree about how this 
scenario might play out. They line up 
on a continuum between the hard-
landing and soft-landing contingents, 
often according to what they consider 
the underlying source of global imbal-
ances. Those who attach a high prob-
ability to a hard-landing scenario—that 
is, a rapid, disruptive adjustment in dol-
lar exchange rates and in U.S. real inter-
est rates—often see the current situation 
as largely inexplicable in terms of nor-
mal market behaviors. They attribute it 
to such things as myopic U.S. consum-
ers, unsustainable rates of foreign sav-
ings, excessive U.S. ﬁ  scal expansion, 
or out-and-out currency manipulation 
abroad. Economists of the hard-landing 
We recently invited four international 
economists to the Federal Reserve 
Bank of Cleveland to discuss global 
developments and to help us identify 
and understand the risks that these 
developments present for U.S. mon-
etary policy. This Commentary devel-
ops a key macroeconomic concern 
that emerged from our conversations. 
Federal Reserve Bank of Clevelandstripe see the current situation as pre-
cariously balanced and therefore subject 
to rapid adjustment. They claim that 
foreigners’ willingness to ﬁ  nance the 
deﬁ  cit is already starting to wane as the 
current account shifts deeper into deﬁ  cit 
and as U.S. economic growth prospects 
slow relative to the rest of the world. 
In contrast, economists of the soft-
landing persuasion view the U.S. 
current account deﬁ  cit as a natural 
market outcome and for that reason 
believe that the adjustment process will 
be orderly. The savings and investment 
patterns that underlie the U.S. current 
account deﬁ  cit have generally followed 
market incentives. In a world that is 
not hamstrung by restrictions on cross-
border ﬁ  nancial ﬂ  ows, funds will natu-
rally move from countries with high 
savings rates relative to their own 
investment opportunities to coun-
tries with low savings rates relative to 
their investment opportunities. Until 
recently, for example, U.S. growth 
had typically outpaced that of other 
developed countries, and despite the 
recent slowing, foreigners’ conﬁ  dence 
in U.S. growth prospects generally 
remains ﬁ  rm. We should, therefore, 
naturally see wider current account 
deﬁ  cits and surpluses across the globe 
today than we saw 20 or 30 years ago. 
As U.S. growth slows relative to that 
of the euro zone, foreigners may start 
to rethink their decisions, but we are 
unlikely to see a massive shift out of 
dollars. 
   The China Syndrome
Those participants who lean in the 
hard-landing direction pointed out that 
foreign central banks and other ofﬁ  cial 
agents have recently been ﬁ  nancing 
the lion’s share of U.S. current account 
deﬁ  cits. They contend that many of the 
countries that have acquired large dol-
lar reserves are effectively engaged in 
a policy of supporting the dollar rela-
tive to their domestic currencies. While 
their interventions have helped the 
Federal Reserve maintain a reasonably 
modest inﬂ  ation rate and have kept 
interest rates relatively low, they pose a 
risk of reversal. To be sure, the chances 
of an abrupt change in this tacit policy 
may be small, but the potential impact 
could be quite large. 
China, for example, closely manages 
its exchange rate and has accumulated 
massive holdings of ofﬁ  cial dollar 
reserves. At over $1.3 trillion, most 
of which appears to be held in liquid 
dollar-denominated assets, China’s 
ofﬁ  cial reserves now exceed those 
of any other nation. China issues 
sterilization bonds to its banking 
sector in an attempt to soak up the 
excess renminbi liquidity that its 
reserve acquisition creates. This mech-
anism channels domestic savings into 
ﬁ  nancing China’s external position. 
But should the type of ﬁ  nancing—
ofﬁ  cial or private—matter? Are ofﬁ  cial 
ﬁ  nancial sources less reliable (that is, 
more prone to rapid ﬂ  ight) than 
private sources? 
Many ﬁ  nancial analysts have recently 
suggested that emerging-market econo-
mies are diversifying their reserve 
holdings away from dollars, or are 
planning to do so. The relevant data 
have many technical and measure-
ment problems, but IMF evidence does 
indeed suggest that the composition of 
ofﬁ  cial reserves is shifting away from 
dollar-denominated assets toward euro-
denominated assets. Ofﬁ  cial foreign 
agencies, however, do not seem to be 
selling off their dollars. Instead, they 
are adding euro-denominated assets 
to their portfolios faster than dollar-
denominated assets, thereby changing 
the composition. 
Some participants questioned whether 
such diversiﬁ  cation would have much 
impact on the dollar. They point out that 
dollar- and euro-denominated assets 
are close substitutes; that is, they have 
very similar risk proﬁ  les. Consequently, 
an ofﬁ  cial shift from dollars to euros, 
while ultimately altering the currency 
composition of both ofﬁ  cial and private 
portfolios, would have minimal—if 
any—effect on exchange or interest 
rates. The overall ofﬁ  cial-sector portfo-
lio would shift to hold relatively fewer 
dollars and more euros, while the aggre-
gate private-sector portfolio would do 
just the opposite. 
Others point out that even if ofﬁ  cial 
and private holders of dollar assets 
began to view them as increasingly 
risky, a wholesale shift from dollars is 
not in the interest of foreign monetary 
authorities. A rapid shift would prompt 
a steep (hard-landing-style) dollar 
depreciation and force them to realize 
valuation losses on the unsold portion 
of their portfolios. Ofﬁ  cial holders of 
dollars are no more likely to diversify 
quickly than are private holders of 
dollar-denominated assets. In short, the 
prospects of an ofﬁ  cially induced hard 
landing seem very slight. 
   What’s a Policymaker to Do? 
In a world of signiﬁ  cant interna-
tional risks, how should a central 
bank behave? Should the Federal 
Reserve respond directly to interna-
tional shocks, such as sharp increases 
in imported commodity prices or rapid 
dollar depreciation, or should it only 
respond to international developments 
insofar as they conﬂ  ict with its domes-
tic objectives? 
Many participants argue that the Fed-
eral Reserve should focus policy solely 
on maintaining inﬂ  ation within a stated 
target range over some reasonable time 
horizon. Even though the System has 
had a fairly good track record in recent 
years, a clearly deﬁ  ned inﬂ  ation objec-
tive would anchor long-term inﬂ  a-
tion expectations against unforesee-
able developments. The gains might 
be small, but there are gains to be had 
nonetheless. 
Within this framework, exchange rate 
ﬂ  uctuations or commodity-price shocks 
might occasionally push the measured 
inﬂ  ation rate beyond the target range. 
The Federal Reserve would respond 
only as necessary to pull the inﬂ  ation 
rate back within the target range and to 
maintain the target over the long term. 
Under a credible inﬂ  ation target, short-
term misses emanating from interna-
tional surprises would not affect long-
term inﬂ  ation expectations and, through 
that route, economic behavior. 
Others, however, believe that the 
United States has little to gain from a 
formal inﬂ  ation target. In recent years, 
the Federal Reserve—like many other 
central banks—has achieved a fair 
degree of price stability and credibil-
ity with respect to maintaining a low 
inﬂ  ation rate even without formal inﬂ  a-
tion targets, and they question whether 
such targets could enhance the System’s 
credibility any further. When a central 
bank, which maintains a reasonably 
low rate of inﬂ  ation, adopts a formal 
inﬂ  ation target, it must convincingly 
explain small deviations from that tar-
get. A series of short-term misses, if 
not convincingly explained, might even 
reduce credibility. A central bank with a formal inﬂ  ation target might ﬁ  nd oil 
or other international commodity price 
shocks especially problematic, because 
such price jolts might also weaken 
economic activity and require a long 
period before the inﬂ  ation rate returned 
to its target range. 
A few participants, however, would 
even broaden the scope of Federal 
Reserve policy beyond its traditional 
goals. Inﬂ  ation is a problem, they note, 
largely because it temporarily distorts 
the prices of some goods relative to 
others. But exchange rate changes 
that reﬂ  ect new information about 
future fundamentals can have similar 
effects. Because goods prices do not 
respond as quickly as exchange rates 
to new information, market devel-
opments that affect exchange rates 
will—much like inﬂ  ation—distort the 
price of domestically produced goods 
relative to imported goods. Ideally, if 
the Federal Reserve’s monetary policy 
responded to very large exchange rate 
movements, it might be able to off-
set the distortionary impacts of such 
exchange rate changes and improve the 
economy’s allocative efﬁ  ciency. 
   What Have We Learned?
Monetary policymakers have always 
had to contend with risk, and the grow-
ing globalization of goods and ﬁ  nan-
cial markets over the past few decades 
has not appreciably changed that fact. 
If anything, the past 20 years have 
witnessed a vast improvement in the 
results of monetary policy. Inﬂ  ation 
has slowed, and real economic ﬂ  uctua-
tions have diminished. The gains have 
been so signiﬁ  cant that many econo-
mists now refer to the period as the 
“Great Moderation.” 
If the risks have not changed, what 
accounts for the Great Moderation? 
Central bankers have learned that in 
a naturally uncertain world, lessen-
ing the uncertainty associated with 
monetary policy is helpful. Whether 
they have adopted formal inﬂ  ation tar-
gets or not, most have focused policy 
more directly on maintaining reason-
able price stability. In addition, cen-
tral banks are becoming increasingly 
transparent about their monetary policy 
deliberations. They have accumulated 
credibility, which seems to pay large 
dividends in a risky world. 
   Our thanks to
●  Kathryn Dominguez
  Professor of Public Policy
  Gerald R. Ford School of 
    Public Policy and Professor of
    Economics, College of 
    Literature, Science, and the Arts
  University of Michigan
●  Charles Engel
 Professor
  Department of Economics 
    and Department of Finance
 University  of  Wisconsin
●  Kenneth Kuttner
  Danforth-Lewis Professor of 
  Economics
 Oberlin  College
●  Brad Setser
 Senior  Economist
  Roubini Global Economics
FIGURE 2  NET INTERNATIONAL INVESTMENT POSITION
FIGURE 1  CURRENT ACCOUNT BALANCE
Sources: Bureau of Economic Analysis; Haver Analytics.
Sources: Bureau of Economic Analysis; Haver Analytics.
–900
–800
–700
–600
–500
–400
–300
–200
–100
0
100
1980 1983 1986 1989 1992 1995 1998 2001 2004
–9
–8
–7
–6
–5
–4
–3
–2
–1
0
1
Billions of U.S. dollars Percent of GDP
–4,000
–3,500
–3,000
–2,500
–2,000
–1,500
–1,000
–500
0
500
1,000
1,500
1980 1983 1986 1989 1992 1995 1998 2001 2004
–40
–35
–30
–25
–20
–15
–10
–5
0
5
10
15
Billions of U.S. dollars Percent of GDPOwen F. Humpage is an economic advi-
sor at the Federal Reserve Bank of 
Cleveland.
The views expressed here are those of the 
author and not necessarily those of the 
Federal Reserve Bank of Cleveland or 
the Board of Governors of the Federal 
Reserve System or its staff. 
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We invite comments, questions, and sug-
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Global risks to U.S. monetary policy

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