While central bankers must focus on delivering price stability and other mandates in their own countries, they must also monitor international developments closely because national trade and financial markets have become increasingly interconnected. Sandra Pianalto, president and chief executive officer of the Federal Reserve Bank of Cleveland, explores how the globalization of financial markets could affect U.S. monetary policy and explains how a commitment to price stability and policy transparency can help monetary policymakers deal with challenging international developments. A version of this speech was presented to the Marshall Forum on Transatlantic Affairs in Tremezzo, Italy, on March 18, 2006.Monetary policy

Sandra Pianalto

English

Research Papers in Economics

May 1, 2006
Federal Reserve Bank of Cleveland
Monetary Policy in an Interdependent World
by Sandra Pianalto
ISSN 0428-1276
While central bankers must focus on
delivering price stability and other
mandates in their own countries, 
they must also monitor international 
developments closely because
national trade and financial markets
have become increasingly intercon-
nected. Sandra Pianalto, president
and chief executive officer of the 
Federal Reserve Bank of Cleveland,
explores how the globalization of
financial markets could affect U.S.
monetary policy and explains how 
a commitment to price stability and
policy transparency can help mone-
tary policymakers deal with challeng-
ing international developments. 
A version of this speech was pre-
sented to the Marshall Forum on
Transatlantic Affairs in Tremezzo,
Italy, on March 18, 2006.
T he key objectives of the Federal
Reserve’s monetary policy are to main-
tain long-term price stability and to 
foster maximum sustainable economic
growth and high employment in the
United States. As a member of the 
Federal Open Market Committee—the
group that sets monetary policy in the
United States—I conceive of these pol-
icy objectives solely in national terms—
inflation and growth rates in the United
States. Nevertheless, I realize that if I am
to achieve these objectives, I cannot
ignore international developments. We
live in a closely integrated world, and it
becomes more so every day.  
Today, I will describe how I think about
monetary policy in an interdependent
world. First, I will explain how policy-
makers throughout the world have
reached a remarkable consensus on the
importance of price stability. Then I will
explore how the globalization of finan-
cial markets could affect U.S. monetary
policy. Finally, I will explain how a 
consensus for price stability has made
monetary policy more predictable and,
therefore, more effective in dealing with
any type of global adjustment that we
might face. 
Of course, the views that I express today
are my own. I do not presume to speak
for any of my colleagues in the Federal
Reserve System. 
■ The Consensus for Price 
Stability
Over the past couple of decades, mone-
tary policymakers, government officials,
and the public have come to recognize
that long-term price stability is the best
contribution that a central bank can
make to a nation’s economic prosperity.
By long-term price stability, I mean a
rate of inflation that consistently remains
so low and stable that it does not become
embedded in business or household
expectations and disrupt their economic
decisions.  
Attaching a precise number to this defin-
ition of price stability is very difficult,
and central banks differ in many of the
mechanical details. Nevertheless, those
that focus on maintaining a low stable
rate of inflation generally appear to be
satisfied with an inflation rate in the 
1 percent to 2 percent range.  
Over the past 25 years, the world’s 
monetary authorities have been very 
successful at reducing the overall global
rate of inflation. Among the industrial-
ized countries, the rate of inflation fell
from 9 percent in the first half of the
1980s to 2 percent early in this decade.
The inflation performance among devel-
oping countries was even more impres-
sive. Their inflation rate fell from
roughly 30 percent to 6 percent over the
same time period. In many countries and
regions, central banks have achieved this
goal through institutional independence,
demonstrated commitment, and clear
communication. 
To understand why long-term price sta-
bility is so important to a nation’s eco-
nomic prosperity, we need only recall a
time when price stability was not the
global norm. While this is not a uniquely
American story, I will describe the U.S.
experience, since I know that situation
best. During the so-called “Great Infla-
tion” of the late 1960s and the 1970s,
confidence in U.S. monetary policy was
badly shaken. Faced with a series of
financial crises and energy-price shocks,
Federal Reserve policymakers did not
follow a consistent and clearly articu-
lated policy. They alternatively tightened
and loosened monetary policy in a futile
attempt to achieve conflicting economic
targets, with the result that they attained
none of them. 
Inflation reached double-digit levels,
and the United States experienced the
longest and deepest recessions of the
postwar period. Because businesses and
households expected inflation to keep
rising, they often diverted resources
away from growth-enhancing invest-
ments to activities that shielded their
wealth. Ultimately, the potential for
long-term economic growth in the
Unites States slowed. Things changed for the better beginning
in the early 1980s. During the chair-
manships of Paul Volcker and Alan
Greenspan, the Federal Reserve low-
ered core inflation in the United States
from approximately 13 percent in 1980
to around 2 percent in recent years.
This outcome was achieved even in the 
face of periodic energy-price spikes,
stock-market disruptions, international
financial crises, and recessions. 
It was not an easy task. Inflation did not
decline along a smooth, linear path, but
the FOMC quickly responded to devia-
tions in the process and kept its focus on
long-term price stability. As time went
on, economists noticed that people’s
inflation expectations no longer reacted
very strongly to financial crises, energy-
price shocks, or dollar depreciations.  
Over these 25 years of focusing on price
stability, recessions became less fre-
quent and comparatively mild. By the
1990s, long-term growth picked up. 
Policymakers began to associate price
stability with long-term economic
growth and employment. Economic
studies confirmed this connection.
Countries with excessive rates of infla-
tion find it harder to sustain high rates
of economic growth than countries with
low rates of inflation. 
The relationship between price stability
and economic growth is important,
because even small changes in a coun-
try’s long-term economic growth can
have large effects on the well-being of
its people over their lifetimes. An econ-
omy growing at 3
1/2 percent per year
will double its citizens’standard of liv-
ing in about 20 years, whereas an econ-
omy growing at only 2 percent per year
does so in about 35 years. 
So my goal as a monetary policymaker
is to promote maximum sustainable
long-term growth in the United States
through price stability. I conceive of
these objectives only in domestic
terms—as do my counterparts at the
European Central Bank, the Bank of
England, the Bank of Japan, and at most
other central banks. But like central
bankers across the globe, I realize that I
cannot hope to achieve these important
domestic objectives if I ignore interna-
tional developments. We live in a
closely interconnected world, especially
in terms of financial markets. 
■ Globalization and Monetary
Policy
The globalization of world markets has
been progressing at least since the end of
World War II. We usually measure this
process in terms of goods and services
trade. Over the past 50 years, international
trade has steadily grown, generally at a
faster pace than world output. 
We still face many lingering challenges
and some occasional turmoil, but those
countries that have embraced free inter-
national trade have seen their standards
of living rise substantially. The gains
have been so great that we increasingly
find fewer closed, command-style 
economic systems. The People’s Repub-
lic of China, for example, is rapidly
adopting market economics, although it
still has a ways to go. China now has a
strong global presence and offers an
alluring market. 
Although we usually equate globaliza-
tion with international trade, the markets
for goods and services are not the only
ones taking on a global character.
Recently, globalization has entered a
new phase; financial markets are becom-
ing increasingly interconnected. Accord-
ing to the International Monetary Fund,
over only the last 15 years, the gross
external assets and liabilities of industri-
alized countries—and to a less extent
emerging-market economies—tripled,
on average, as a percent of GDP.
1 In the
United States, for example, gross for-
eign assets and liabilities equaled 80
percent of GDP in 1990; today they are
nearly two and a half times bigger—
exceeding 190 percent of GDP. To be
sure, international investors do still
favor the familiar—they still exhibit a
home bias in their portfolio choices—
but they are increasingly willing and
able to seek out higher returns abroad. 
The globalization of financial markets
has direct implications for central banks.
Just as international trade makes goods
prices more sensitive to worldwide
demand and supply pressures, the glob-
alization of financial markets will tie
interest rates in any single country more
closely to interest rates across the globe
and, in the bargain, leave exchange rates
more sensitive to financial flows. 
The United States has been an important
participant in this process of financial
globalization. A nearly unbroken, 23-
year string of current-account deficits
has left foreigners holding substantial—
and still growing—claims on the United
States. In 2005, these claims were esti-
mated at more than $3 trillion, or 26 per-
cent of U.S. GDP. When the United
States runs a current-account deficit, it
imports more than it exports and pays
for the difference by issuing financial
claims to the rest of the world. These
include U.S. government securities, cor-
porate stocks and bonds, and bank
accounts. When foreigners acquire these
claims, they channel their savings into
the United States. 
Economists have offered many reasons
for these current-account imbalances.
Some say that U.S. consumers do not
save enough and that the U.S. govern-
ment borrows too much. Others claim
that foreign economies do not provide
attractive investment climates or that
foreign consumers save too much. Still
others contend that our current-account
deficits reflect the strategic actions of
foreign central banks that acquire dol-
lars by impeding the way their exchange
rates adjust. 
The list of possible explanations is long,
and the contributing factors are com-
plex. I am not sure that there is one ulti-
mate cause for these patterns, but that
does not really matter. The important
point is that in a closely interconnected
world, people can buy and sell and bor-
row and lend across the globe. They
channel their investments where they
believe returns will be greatest in pro-
portion to the risk. The consequences of
their actions accumulate in complicated
ways that will often produce large cur-
rent-account deficits and surpluses.  In
fact, in a closely integrated world, we
should expect to see sizeable current-
account imbalances. 
Like many observers, I realize that our
current-account deficits cannot keep
growing indefinitely. The rest of the
world will not continue to accumulate
ever-growing financial claims against
the United States and channel its savings
here. At some point, international
investors—including governments—
will become reluctant to add additional
dollar-denominated claims to their
portfolios. They might even want to
diversify out of dollars to some extent.
At that point, higher interest rates on
dollar-denominated assets and, possibly,
a decline in the spot value of the dollar
will be necessary to overcome their
reluctance. I do not claim to know when we might
reach this point or how these events
might play out. No one does. Many 
people thought that a reversal was
beginning in early 2002, when the cur-
rent-account deficit began rising above 
4 percent of GDP, and the dollar started
to depreciate. Yet the reversal did not
happen. 
The chances that international investors
will start placing funds elsewhere will
undoubtedly grow as economic activity
outside the United States continues to
expand.  Since 2000, U.S. economic
activity has generally outpaced eco-
nomic activity in much of the rest of the
world. As economic growth throughout
the world—notably in Europe and
Japan—continues to accelerate and
opens up attractive alternatives for
investment, the United States might find
it increasingly difficult to attract inflows
of foreign savings. 
Should these international develop-
ments start to unfold, I cannot ignore
them if I hope to attain my domestic
economic objectives of price stability
and maximum sustainable economic
growth with high employment. This 
situation poses two interconnected 
challenges: First, should international
investors seek a risk premium to com-
pensate them for taking large dollar
positions in their portfolios, they will
encourage a dollar depreciation and
might exert some upward pressure on
U.S. interest rates. A dollar depreciation
could eventually raise the dollar price 
of all U.S. traded goods—imports,
import-competing goods, and exports.
The extent to which higher prices for
these traded goods then pass through 
to the overall U.S. inflation rate will
depend critically on how monetary 
policy responds. Such a development
would complicate the task of maintain-
ing domestic price stability.
The second challenge is not directly
“monetary” in nature, but it is inter-
twined with it. To achieve a fundamen-
tal change in the U.S. current account,
domestic savings—both household and
public—must rise, or domestic invest-
ment will fall, and resources—both
labor and capital—must shift to expand
production in the export and import-
competing sectors of the U.S. economy.
How quickly and smoothly these
adjustments take place will depend on
the severity of frictions in the U.S. econ-
omy. Frictions are always with us.
Wages and prices are often set by 
contract or custom, which slows their
response to changing economic circum-
stances. Information is typically costly
to acquire and takes time to disseminate,
and just the act of adapting to economic
change involves resource costs that slow
the adjustment process. Yet a credible,
predictable monetary policy can help
reduce the impact of such frictions. 
■ A Predictable Monetary
Policy 
Although I believe that current interna-
tional imbalances are not sustainable
indefinitely, and even though I would
not venture to predict when a reversal
might take place, I am optimistic that
the adjustment process will be orderly. I
predicate my optimism on history and
on the recent behavior of central banks. 
Large, persistent current-account imbal-
ances are not a new phenomenon. We
experienced them in the late nineteenth
century, during the 1920s and 1930s, and
again during the Bretton Woods era—the
late 1940s to the early 1970s. Michael
Bordo, a noted economic historian from
Rutgers University and a visiting scholar
at the Federal Reserve Bank of Cleve-
land, has shown that markets can adjust
to international imbalances in an orderly
way when they have confidence in
underlying monetary institutions.
2
Over the last 25 years, the Federal
Reserve and central banks around the
world have increased the credibility and
the predictability of their monetary poli-
cies, primarily by fulfilling a commit-
ment to price stability. This predictabil-
ity can enhance the efficiency of
monetary policy. When our actions are
transparent and our pronouncements are
credible, the public is less likely to
incorporate temporary, relative price
changes into their long-term inflation
expectations, as they unfortunately did
in the 1970s. When policy is predictable
and expectations are benign, small pol-
icy responses to economic shocks can
have faster, favorable price effects with
lower costs in terms of output and
employment, as we saw in the 1990s.
Maintaining a credible commitment to
low and stable inflation is the best con-
tribution that central banks can make to
the challenge of global adjustment. 
■ Conclusion
I do not intend my remarks today to be
a forecast of likely developments in
global markets. Instead, I intend them
as a comment on the growing impor-
tance of globalization and on the
achievements that central banks have
made over the last 25 years. Monetary
policymakers, like me, who hope to
achieve long-term price stability and
maximum sustainable economic
growth with high employment can no
longer ignore the interconnectedness of
global markets. In that respect, the U.S.
current-account deficit and associated
global savings and investment patterns
could present some serious challenges
as worldwide expansion continues. 
Yet we face them on the best possible
terms. Through a 25-year commitment
to price stability and policy trans-
parency, central banks have improved
the predictability—and the efficiency—
of monetary policy. 
■ Footnotes
1. International Monetary Fund, 
“Globalization and External Imbal-
ances,” World Economic Outlook,
(April 2005), pp. 109–56.  See also:
International Monetary Fund, “Global
Imbalances: A Savings and Investment
Perspective,” World Economic Outlook,
(September 2005), pp. 91–124.  
2. Michael D. Bordo. 2006. “Global-
ization and Imbalances in Historical
Perspective,” Federal Reserve Bank of
Cleveland, Policy Discussion Papers,
no. 13.  Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
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Sandra Pianalto is the president and chief
executive officer of 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, the Board of 
Governors of the Federal Reserve System, or
its staff. 
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Monetary policy in an interdependent world

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