- By Phil LevyPhil Levy is Senior Fellow on the Global Economy, The Chicago Council on Global Affairs, and teaches strategy at Northwestern University’s Kellogg Schoool of Management.
The new chair of the Federal Reserve, Janet Yellen, is far too smart to have thought the job would be easy. Yet she took office amid plentiful criticism of the U.S. central bank and calls for it to rethink its approach.
Yellen takes over the Fed as it works to extricate itself from a policy of extraordinary measures meant to boost the money supply. The Fed has gone from pumping $85 billion into the economy each month to $65 billion, with promises to reduce these purchases further (a policy known as the "taper"). Although we’re well into the realm of unconventional monetary policy (quantitative easing), some of the old rules apply — tighter monetary policy and the promise of more to come can draw money back from the far corners of the world.
That is what has happened. Markets such as Brazil, Turkey, and India all enjoyed inflows of foreign investment when global monetary policy was loose. The bout of U.S. tightening has led some investors to depart these markets, driving down their stock markets and their currencies and compelling some of them to raise interest rates to painful levels (which can have the effect of persuading those foreign investors to stay).
The renowned economist Raghuram Rajan, recently installed atop India’s central bank, made a forceful case that the U.S. Fed should care more about how its policies affect emerging markets. "International monetary cooperation has broken down," he said. "The U.S. should worry about the effects of its polices on the rest of the world.… We would like to live in a world where countries take into account the effect of their policies on other countries and do what is right, broadly, rather than what is just right given the circumstances of that country."
He is not alone in this view. A Forbes contributor weighed in: "The Fed should not be ‘going it alone’ on monetary policy decisions of this magnitude.… It must take into account the state of the global economy. The Fed is in effect the central bank of the world. It is time it behaved like it."
Who could object to the idea of looking out for the well-being of other countries and adopting a global view?
Eswar Prasad, a professor of trade policy at Cornell University, offered a contrary view, focusing on the ability of emerging markets to look out for themselves. He also touched on the reason that Yellen will not accommodate the critics — the Fed has its mandate set by law.
The problem she faces is a basic one: too few instruments, too many targets. The core Fed instrument is the money supply. In this time of more creative monetary policy, it can seem that the Fed has many instruments (regulation, different rates, public statements about the future, outright purchases of bonds and mortgages), but they really boil down to one — how fast is the money supply expanding or contracting. Even if it were to remain blissfully ignorant of the world around it, the Fed would already have a potential difficulty. With this one instrument, it is supposed to meet two objectives: price stability and a reasonable level of employment. This is a bit different from many central banks tasked with only the first (also known as keeping inflation under control).
There is no tension if you have teetering prices and plunging employment. In such a case, the Fed tries to boost the money supply, since that should bolster both prices and economic activity (jobs). The problem comes if, for example, there are signs of inflation, but unemployment remains stubbornly high. Does one then cut money-supply growth to contain inflation (at the expense of jobs) or allow prices to rise to tamp down unemployment? As difficult as that balance can be, it is the one the Federal Reserve is formally required to take on.
The problem with adding international cooperation to the mix is that there are no new levers to meet the objective of prosperity in fellow countries. If the Fed committee (which Yellen chairs) determines that its U.S. objectives are best served by a $10 billion-per-month taper, then there is no legal basis for doing anything less (an adjustment which would presumably risk inflation). In practice, these calculations are not so precise, but the Fed has its hands full at home. It won’t revise its solutions for concerns abroad.
In her testimony this week, Yellen promised nothing more than that she would keep an eye on global markets. This demonstrated an early mastery of the crucial Fed art of making empty statements. Tact without accommodation. Expect more of the same.