Commentary Type

Fed Must Stay Tuned to the World, Not Be a Global Central Bank


The United Kingdom’s historic and unexpected decision to part ways with the European Union shows exactly why the US Federal Reserve’s interest rate policy can’t operate in a vacuum. Fed Chair Janet Yellen cited the possibility of “Brexit” as one reason why the Fed decided not to raise interest rates earlier this month. Was she right! Financial markets have reacted fiercely, with the global selloff wiping out some $3 trillion in global stock values before finding a footing, and the US dollar darting higher.

Blaming foreigners has become all too common a habit, usually a misguided one, in today’s political landscape.

Still, when examining critiques of US Federal Reserve policy from the perspective of emerging economies, it’s important to keep in mind one general principle, one all too applicable to Brexit itself: Blaming foreigners has become all too common a habit, usually a misguided one, in today’s political landscape.

Warnings by policymakers in the developing world that the Fed’s interest rates are somehow harming their economies, either by channeling too much or too little capital into their countries—depending on the Fed’s latest actions—ring hollow today.

Admittedly, the interest-rate policymaking of the US Fed has attained a larger-than-life presence in global financial markets that is of questionable value, and that arguably contributes to a great deal of volatility in the world economy and global markets. But this is not the Fed’s fault, at least not directly.

If anything, it is the increasing role of finance in the global economy, which some economists argue comes at the expense of stronger activity in more productive sectors, that has dictated the Fed’s role as perhaps the most fundamental leading indicator of financial market activity, both in the United States and overseas. Traders in places like Mexico and Brazil, Latin America’s two largest economies, often marvel at how much more their local markets react to pronouncements by the Fed than to any action by their own central banks.

Fed [policy] has attained a larger-than-life presence in global financial markets that is of questionable value.

To be sure, the Federal Reserve has helped create this situation by underwriting the deregulatory process that allowed megabanks and nonbank financial firms to become too big to fail, so big that their trades can and do affect global markets, often in perceptible waves. But the Fed’s efforts to revive a moribund US economy, given the Congress’ unwillingness to devote budget resources to boosting employment and growth, are not the cause of downturns in the emerging world.

Fed Vice Chairman Stanley Fischer addressed the issue in a 2014 speech entitled "The Federal Reserve and the Global Economy."

“My teacher Charles Kindleberger argued that stability of the international financial system could best be supported by the leadership of a financial hegemon or a global central bank,” he said. “But I should be clear that the US Federal Reserve System is not that bank. Our mandate, like that of virtually all central banks, focuses on domestic objectives.”

At the same time, Fischer noted, the Fed must take international factors into account insofar as they might affect the outlook for the American economy.

“To meet those domestic objectives, we must recognize the effect of our actions abroad, and, by meeting those domestic objectives, we best minimize the negative spillovers we have to the global economy,” he said. “And because the dollar features so prominently in international transactions, we must be mindful that our markets extend beyond our borders and take precautions, as we have done before, to provide liquidity when necessary.”

In short, just because markets have become a global casino whose bets move in tandem doesn’t mean that US monetary policy is the culprit for all that ails overseas economies. That kind of blanket blame game is just too easy—and most often wrong.

So what should the Federal Reserve do? Even before Brexit sharply raised uncertainty about the future of Europe’s and the world’s economic prospects, the latest US employment report showed a sharp decline in job growth to a meager 38,000 in May, the weakest in more than five years, making Fed officials rightly reluctant to raise interest rates again following a tentative December increase.

Those calling for a tighter monetary policy after nearly seven years of zero official interest rates and three rounds of asset purchases are driven by worries that such a prolonged period of loose policy will lead to either financial bubbles or inflation. But neither is evident on the horizon at the moment.

Indeed, US inflation is actually lagging below the Fed’s 2 percent target, and has done so for several years. Inflation expectations, seen as a predictor of future inflation, have been trending lower in a worrisome fashion.

Why is low inflation a bad thing? Because when it’s persistent, it can be a sign that the economy is running well below its potential, while workers’ wages and their purchasing power are stuck in neutral.

These conditions suggest that the official 4.7 percent jobless rate is a weak approximation of the true health of the labor market, which remains plagued by low workforce participation, rampant underemployment, and persistent long-term joblessness. Wage growth, another key to pushing consumer prices higher on a consistent basis, remains nowhere to be seen, despite the occasional hint of a pickup in average hourly earnings.

In short, the Fed, particularly with no prospect of a fiscal stimulus directed at the job market any time soon, should take a do-no-harm approach to policy. Officials should sit tight and recognize that the weakest economic recovery in modern history allows them plenty of room to wait and see whether growth can continue without any action from the Fed.

It’s notable that some of the same big bank executives who begged the Fed to slash interest rates during the financial crisis, when their firms’ survival was at stake, are now calling for rate hikes, with no regard for the ability of US workers to get by.

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