Monetary policy in a dynamic, global environment

Business Economics, Jan, 1996 by Robert T. Parru

Changes in technology and the surge in international trade have impacted domestic monetary policy. However, these changes have not weakened the Federal Reserve's ability to affect aggregate demand, have not exposed U.S. interest rates and monetary policy to undue influence from abroad nor have they broken the link between monetary policy and domestic inflation.

The theme of this conference is economic forecasting in a dynamic, global environment. I'm sure that many of the other speakers are going to touch on a number of the changes that have affected our ability as economists to make forecasts.

And the changes are legion. There's the dramatic advance in technology that has revolutionized U.S. financial markets. There's the equally dramatic surge in international trade as countries all over the world have opened their markets to greater crossborder flows of goods and financial assets.

These changes certainly have an impact on monetary policymaking as well. In fact, some observers would go even further; they'd say these changes have essentially disarmed monetary policy, i.e., they question whether the Fed still has the ability to pursue a low-inflation policy in this dynamic environment. In fact, one commentator pushed the point so far as to call the Fed a "toothless tiger on inflation."

In this paper, I want to address three questions that arise about monetary policy's effectiveness in a dynamic, global environment: (1) Have the changes in our domestic financial market weakened the Fed's ability to affect aggregate demand? (2) has the globalization of financial markets exposed U. S. interest rates, and hence monetary policy, to undue influence from abroad? and (3) has global competition broken the link between domestic monetary policy and domestic inflation? In answering these questions, I hope to convince you of two major points: (1) Monetary policy certainly is still effective; and (2) the Fed's commitment to lowering inflation is as strong and as necessary as ever.

CHANGES IN FINANCIAL MARKETS

Let me start by looking at changes in the U.S. financial market and their impact on the Fed's effectiveness. Over the past two decades, deregulation, vastly improved information and communications technology, and advances in our understanding of finance have combined to accelerate the pace of financial innovation.

These innovations have had far-reaching consequences. New instruments and markets reduce the costs of bringing borrowers and savers together and increase the opportunities to manage the risk. At the same time, changes in financial markets have affected the links between monetary policy and the economy.

But have these changes actually altered the Fed's ability to conduct monetary policy? The answer is a categorical "No."

1. Even with these changes, the Fed still can affect short-term interest rates. That means we still have an impact on the cost of borrowing from banks, from other intermediaries, and directly in capital markets.

2. There's no strong evidence that aggregate demand has become any less sensitive to monetary policy. Let me give you an example from the housing industry that shows how financial innovations have cut both ways": the elimination of Reg Q deposit ceilings has lessened the adverse disintermediation effect on the housing industry, but this is to some extent counterbalanced by the introduction of ARMs, which have arguably increased the price sensitivity of housing to monetary policy. Furthermore, when we put the issue to the empirical test, the results indicate that the magnitude of interest-rate changes needed to achieve a given effect on output is about the same now as it was in the 1960s and 1970s.

3. Perhaps most important, even if continuing financial innovation does make demand less sensitive to policy, the Fed can always adjust its response to compensate for the change. When the economy needs to slow down, the Fed can just step a little harder on the brakes; and when it needs to speed up, it can just push harder on the accelerator.

THE U.S. IN THE WORLD MARKETPLACE

Next, I'd like to look at this country's evolving role in the world marketplace and its effect on the conduct of U.S. monetary policy. In the past twenty-five years, international trade in goods and services has burgeoned as the cost of transportation and communication has shrunk and as trade barriers have fallen. And financial markets have become more global as well, prompted by deregulation, technology, and ingenuity. Every day, over a trillion dollars' worth of transactions take place on foreign exchange markets. And we've all heard about the pools of money that race around the world's stock, bond, and currency markets in search of the highest returns each day.

But does the globalization of financial markets expose U.S. interest rates to undue influence from road? In other words, does the U.S. economy's openness undermine the Fed's ability to conduct monetary policy?

Again, the answer is in the negative. And there are three reasons why. Two of the reasons are related to characteristics of the United States in the global economy. And the third is related to our policy choice of flexible exchange rates.