St. Louis Fed's Bullard Discusses Two Views of International Monetary Policy Coordination

LOS ANGELES – Federal Reserve Bank of St. Louis President James Bullard addressed the question of whether monetary policy should be better coordinated across countries as part of his presentation on Monday at the 27th Asia/Pacific Business Outlook Conference, hosted by the University of Southern California Marshall School of Business.

During his presentation, titled “Two Views of International Monetary Policy Coordination,” Bullard noted that the policy coordination debate has again moved to center stage in recent years, adding that unconventional monetary policy in the U.S., in particular, has been met with criticism from emerging markets.  The “taper tantrum” of the summer of 2013 re-energized the debate, he said.  During this time, longer-term U.S. interest rates increased, emerging-market currencies depreciated against the U.S. dollar, capital flowed to the U.S. and emerging-market stock indexes declined.

He discussed two ways of evaluating the taper tantrum.  “In a traditional view, this is merely the global macroeconomic equilibrium in action,” he said.  “The gains from international monetary policy coordination in this view are small,” Bullard noted.  In an alternative view, which is more radical and less widely-accepted, the worldwide equilibrium may be unnecessarily volatile due to U.S. policy.  Bullard added that this alternative view may better fit the emerging markets’ perspective.

“The traditional view provides a good description of the commentary of many defenders of U.S. monetary policy, including me,” Bullard said.

The Traditional View

In the traditional view, monetary policymakers in each country follow “good” policy focused on only domestic variables, Bullard said.¹  He noted that “good policy” obeys the Taylor principle, meaning that nominal interest rates are adjusted more than one-for-one with deviations of inflation from an inflation target.

Any gains from policy cooperation in the traditional view stem from taking into account the effect of foreign economic activity on the domestic marginal cost of production, Bullard said.  Under policy cooperation, a central bank should respond to foreign inflation, as well as domestic inflation.  “But policymakers do almost as well with respect to their goals by simply ignoring this effect.  Hence the gains are small,” he explained.

Many have concluded from this line of thinking that it does not pay to worry about international monetary policy cooperation.  “Possible gains are small, and it would be hard to get the world’s policymakers to play the cooperative equilibrium,” Bullard said.

The Alternative View

Under the alternative view, Bullard explained that all the features of the international economy are the same as in the traditional view.  The only difference is that monetary policymakers in one or more countries are not following “good” policy.²  In this case, this would mean that at least one national policymaker does not adjust the degree of policy accommodation more than one-for-one in response to deviations of inflation from target; that is, monetary policy does not obey the Taylor principle in at least one country.  “The result is potentially a lot of extra volatility in the global economy,” he said.

Bullard noted that it may be reasonable to assume that some countries are not obeying the Taylor principle.  “These are not ‘normal times’ for monetary policy in the U.S. economy.  In particular, it is difficult for policy to respond to declines in inflation when the policy rate is subject to the zero lower bound,” he said, noting that quantitative easing and forward guidance may or may not substitute effectively for more normal policies.

Therefore, “Whether the U.S. is following the Taylor principle or not hinges on what one thinks about unconventional monetary policy,” Bullard said.  “If unconventional U.S. monetary policy is effective, the traditional view is more nearly correct and the gains from international policy coordination would be small.  If unconventional policy is ineffective, the alternative view is more nearly correct and the global gains from the U.S. shifting to a better policy may be large,” he explained.

“I think unconventional U.S. monetary policy has been sufficiently aggressive to replicate the Taylor principle,” Bullard said, adding that there is plenty of room for debate on this issue.

¹ For some literature reflecting the traditional view, see Obstfeld, Maurice and Rogoff, Kenneth.  “Global Implications of Self-Oriented National Monetary Rules,” Quarterly Journal of Economics, May 2002, 117(2), pp. 503-35.  See also Clarida, Richard; Galí, Jordi and Gertler, Mark.  “A Simple Framework for International Monetary Policy Analysis,” Journal of Monetary Economics, July 2002, 49(5), pp. 879-904.

² For an example of the literature on this alternative view, see Bullard, James and Singh, Aarti.  “Worldwide Macroeconomic Stability and Monetary Policy Rules,” Journal of Monetary Economics, October 2008, 55(Supplement), pp. S34-S47.  While this paper was written before the crisis, Bullard noted that it is possibly more relevant today.