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July 13, 2017

Cross-Border Spillovers of Balance Sheet Normalization

Remarks by
Lael Brainard
Board of Governors of the Federal Reserve System
at the
National Bureau of Economic Research’s Monetary Economics Summer Institute
Cambridge, Massachusetts

July 13, 2017

When the central banks in many advanced economies embarked on
unconventional monetary policy, it raised concerns that there might be differences in the
cross-border transmission of unconventional relative to conventional monetary policy. 1
These concerns were sufficient to warrant a special Group of Seven (G-7) statement in
2013 establishing ground rules to address possible exchange rate effects of the changing
composition of monetary policy. 2
Today the world confronts similar questions in reverse. In the United States, in
my assessment, normalization of the federal funds rate is now well under way, and the
Federal Reserve is advancing plans to allow the balance sheet to run off at a gradual and
predictable pace. And for the first time in many years, the global economy is
experiencing synchronous growth, and authorities in the euro area and the United
Kingdom are beginning to discuss the time when the need for monetary accommodation
will diminish.
Unlike in previous tightening cycles, many central banks currently have two tools
for removing accommodation. They can therefore pursue alternative normalization
strategies--first seeking to guide policy rates higher before initiating balance sheet runoff,
as in the United States, or instead starting to shrink the balance sheet before initiating a


I am grateful to John Ammer, Bastian von Beschwitz, Christopher Erceg, Matteo Iacoviello, and John
Roberts for their assistance in preparing this text. The remarks represent my own views, which do not
necessarily represent those of the Federal Reserve Board or the Federal Open Market Committee.
The new commitment stated: “We reaffirm that our fiscal and monetary policies have been and will
remain oriented towards meeting our respective domestic objectives using domestic instruments, and that
we will not target exchange rates.” See Group of Seven (2013), “Statement by G7 Finance Ministers and
Central Bank Governors,” February 12, paragraph 1, The
corresponding Group of Twenty statement included the new commitment: “We will not target our
exchange rates for competitive purposes.” See Group of Twenty (2013), “Communiqué of Meeting of G20
Finance Ministers and Central Bank Governors,” February 16, paragraph 5,

-2tightening of short-term rates, or undertaking both in tandem. Shrinking the balance
sheet and raising the policy rate can both contribute to achieving the domestic goals of
monetary policy, but it is an open question whether alternative normalization approaches
might have materially different implications for the composition of demand and for crossborder spillovers, including through exchange rates and other financial channels.
Before discussing the cross-border effects of normalization, it is worth noting that
the two tools for removing accommodation--raising policy rates and reducing central
bank balance sheets--appear to affect domestic output and inflation in a qualitatively
similar way. This means that central banks can substitute between raising the policy rate
and shrinking the balance sheet to remove accommodation, just as both were used to
support the recovery following the Great Recession.
Insofar as a range of approaches is likely to be consistent with achieving a central
bank’s domestic objectives, the choice of normalization strategy may be influenced by
other considerations, including the ease of implementing and communicating policy
changes, or the desire to minimize possible credit market distortions associated with the
balance sheet. In the case of the Federal Reserve, the Federal Open Market Committee
(FOMC) decided to delay balance sheet normalization until the federal funds rate had
reached a high enough level to enable it to be cut materially if economic conditions
deteriorate, thus guarding against the risk of returning to the effective lower bound (ELB)
in an environment with a historically low neutral interest rate. 3 The greater familiarity
and past experience with the federal funds rate also weighed in favor of this instrument


See, for example, Board of Governors of the Federal Reserve System (2015), “Federal Reserve Issues
FOMC Statement,” press release, December 16,; and Brainard (2015b).

-3initially. Separately, for those central banks that, unlike the Federal Reserve, moved to
negative interest rates, there may be special considerations associated with raising policy
rates back into positive territory.
One question that naturally arises is whether the major central banks’
normalization plans may have material implications for cross-border spillovers--an
important issue that until very recently had received scant attention. This question is a
natural extension of the literature examining the cross-border spillovers of the
unconventional policy actions taken by the major central banks to provide
Although this literature suggests there are good reasons to expect broadly similar
cross-border spillovers from tightening through policy rates as through balance sheet
runoff, the effects may not be exactly equivalent. The balance sheet might affect certain
aspects of the economy and financial markets differently than the short-term rate due to
the fact that the balance sheet more directly affects term premiums on longer-term
securities, while the short-term rate more directly affects money market rates. As a
result, similar to the domestic effects, while the international spillovers of conventional
and unconventional monetary policy may operate broadly similarly, the relative
magnitude of the different channels may be sufficiently different that, on net, the two
policy strategies have distinct effects. For example, as will be discussed at greater length
shortly, the two strategies may have very different implications for the exchange rate.
Moreover, as was evident with the European Central Bank’s (ECB) asset purchases in
late 2014 and early 2015, and as we have seen again in reverse in recent weeks, in
addition to the standard demand and exchange rate channels, expected or actual asset

-4purchases may have spillovers to foreign financial conditions--by lowering term
premiums and the associated longer-term foreign bond yields--that are greater than
conventional monetary policy.
To explore possible differences, it is useful to compare two different approaches
to policy normalization, each of which is designed to have identical effects on aggregate
domestic activity and thus, at least in the long run, on inflation. At one extreme, a central
bank could opt to tighten primarily through conventional policy hikes, while maintaining
the balance sheet by reinvesting the proceeds of maturing assets. At the other extreme, a
central bank could rely primarily on reducing the balance sheet, while keeping policy
rates unchanged in the near term.
The question is whether there are circumstances in which the choice of
normalization strategies, which are similarly effective in achieving domestic mandates,
might matter for the global economy. Where the two approaches have entirely equivalent
effects, the central bank could freely substitute between them without changing the
composition of home demand, and net exports, the exchange rate, and foreign output
would also be unaffected.
Conversely, under different assumptions about the transmission channels of
monetary policy, alternative approaches to normalization can have quite different
implications for foreign economies. Most prominently, the exchange rate may be more
sensitive to the path of short term rates than to balance sheet adjustments, as some
research suggests. 4 Although several papers using an event study approach find on
balance little disparity in the exchange rate sensitivity to short-term compared to long-


See, for instance, Stavrakeva and Tang (2016).

-5term interest rates, this lack of empirical consensus may simply reflect the difficulty of
disentangling changes in short-term and longer-term interest rates, which are highly
correlated. 5
Indeed, the greater sensitivity of exchange rates to expected short-term interest
rates than to term premiums was a key rationale behind the Operation Twist strategy in
the early 1960s. 6 Under Operation Twist, the Federal Reserve and the Treasury made
large-scale purchases of longer-term Treasury securities to drive down yields and
stimulate the economy, which was suffering from an unemployment rate of nearly 7
percent. This policy was combined with a modest increase in short-term interest rates
intended to alleviate the capital outflow pressures that threatened the sustainability of the
Bretton Woods global monetary system. Ultimately, this policy mix did succeed in
reducing long-term interest rates, and also contributed to a reduction in private capital
outflows that relieved pressure on U.S. international reserves, at least for a time.
Let’s turn to a simulation of a highly stylized model to explore how a greater
sensitivity of the exchange rate to conventional policy relative to balance sheet actions
can make a difference in terms of cross-border transmission. In particular, let’s assume a
100-basis-point rise in long-term yields coming from the conventional channel of higher
policy rates has double the effect on the exchange rate as a 100 basis point rise in yields
coming from higher term premiums. 7 If a large country, which is already at potential,
experiences a favorable domestic demand shock, it would need to tighten monetary


See Glick and Leduc (2015), Ferrari, Kearns, and Schrimpf (2016), and Swanson (2017); Swanson
attempts to identify separately the effects of forward guidance and asset purchases.
See Ross (1966), Modigliani and Sutch (1966), Stein (1965), and Alon and Swanson (2011).
This simulation is shown in figure 1 in the appendix. The stylized model is composed of two identical
countries that are linked through trade flows. The model is calibrated so that either type of policy action
keeps the home country’s GDP at baseline.

-6policy to return output to potential. If the central bank chooses to use the short-term
interest rate as its active policy tool, and keeps its balance sheet on hold, the current and
expected path of short-term interest rates rises, putting upward pressure on long-term
bond yields and causing the real exchange rate to appreciate. The stronger currency
coupled with some initial expansion of domestic demand in turn cause a deterioration in
real net exports.
Turning to the effects abroad, the decline in domestic real net exports corresponds
to an increase in foreign net exports, which will tend to boost foreign GDP, other things
being equal. How this affects a particular foreign economy will depend on its
circumstances and the corresponding policy response of the foreign central bank. In the
case where the foreign economy is pinned at the effective lower bound, the increase in
net exports will provide a welcome boost to aggregate demand. By contrast, if foreign
output is already near potential, the foreign central bank will need to respond by
tightening policy in order to keep its economy in balance.
Now, let’s instead consider tightening through the balance sheet. If the same
amount of policy tightening in the country experiencing a positive demand shock is
achieved exclusively through a reduction in the balance sheet, while keeping the policy
rate unchanged, the exchange rate would appreciate to a smaller degree, reflecting the
lower assumed sensitivity of the exchange rate to the term premium than to policy rates.
Net exports would decline by less--reflecting both the smaller exchange rate appreciation
and the smaller rise in domestic demand--and similarly this would result in smaller crossborder spillovers to foreign GDP.

-7Thus, for a foreign economy that is at the effective lower bound, tightening in the
home country through balance-sheet policy will be less welcome than through short-term
rates. The foreign economy will experience less exchange rate depreciation, and so less
of a boost to net exports. In addition, the stimulus to the foreign economy could be
further diluted to the extent that the balance sheet policy boosted term premiums on its
long-term bonds and hence tightened financial conditions, although this effect has not
been built into the simulation model. By contrast, for a foreign economy that is close to
potential, adjustment through the balance sheet in the home country will mean less of a
need for the foreign central bank to respond by tightening policy than under home
country adjustment through conventional policy.
So far, we have considered the case of central banks with freely floating exchange
rates and well-anchored inflation expectations. What about central banks with managed
exchange rates or weakly anchored inflation expectations? To keep the analysis simple,
let’s assume a foreign central bank aims to completely stabilize its exchange rate vis-àvis a core country. Let’s again consider circumstances in which the core country
experiences a positive demand shock that calls for policy tightening. Although the
pegging economy is likely to experience spillovers under either approach to
normalization in the core country, the spillovers are likely to be greater when the core
country tightens through the policy rate. The tightening in the core country will compel
the country that is fixing its exchange rate to tighten policy in sync and the core country’s
currency will rise more against its trading partners with conventional tightening, leading
to greater effective appreciation of the pegging country’s currency as well. Although the
pegging economy will benefit somewhat from the stronger demand of the core country,

-8that benefit is likely to be outweighed by the adverse effects of a tightening of domestic
monetary policy when domestic conditions would not otherwise call for it. Such
considerations may have played a role in the market dynamics experienced by China as
discussions about initiating rate hikes progressed in the United States in the second half
of 2015 and early 2016. 8
Next let’s explore alternative approaches to policy normalization by countries
facing a similar need to tighten. This question is timely; with synchronous expansions
now underway, we may be approaching a turning point before too long. In particular,
let’s consider the case when two large countries, which are assumed identical for the sake
of simplicity, experience the same positive shock to domestic demand. Under these
assumptions, if both economies were to choose the same normalization strategy--putting
primary reliance on either the balance sheet or short-term interest rates--the implications
for the exchange rate and net exports are the same: In both cases, the exchange rate
between the two countries does not change, and neither do net exports between the
countries. Each central bank would adjust interest rates by the same amount--enough to
offset the stimulus from the demand shock--and with interest differentials unchanged,
there would be no pressure on the exchange rate between them to move. 9 Of course, if
there are other economies in the rest of the world that do not experience the same shock,
the choice of normalization strategy does matter, similar to the analysis of spillovers from


See Brainard (2015a). A number of recent studies have considered financial spillovers to EMEs,
including Rey (2014) and Bowman, Londono, and Sapriza (2015). The analysis of Hofmann, Shim, and
Shin (2016) suggests that EMEs may be hurt more if their banks or nonfinancial corporations have
relatively large dollar liabilities, as the larger dollar appreciation associated with the policy rate tool would
precipitate greater EME balance sheet deterioration in this case.
In this simple example, in which the two countries are hit by identical shocks, the offset in spillovers
between the two economies will be complete. If one country faces a larger aggregate demand shock than
the other, then the situation becomes more like the one-country case we examined before, the policy
adjustments lead to spillovers of different magnitudes, and the offset will be partial.

-9the single core country, presumably magnified by the larger combined global weight of
the two economies.
Now let’s turn to the case in which the two central banks choose to rely on
different policy tools. 10 In this case, one country responds to the positive shock by
hiking its policy rate to reduce output to its initial level, while the second country
responds by shrinking its balance sheet. The country that relies on the policy rate to
make the adjustment experiences an appreciation in the exchange rate, a deterioration in
net exports and some expansion of domestic demand, while the country that chooses to
rely solely on the balance sheet for tightening experiences a depreciation of its exchange
rate and an increase in net exports. Thus, while both countries achieve their domestic
stabilization objectives, whether the requisite policy tightening occurs through increases
in policy rates or reductions in the balance sheet matters for the composition of demand,
the external balance, and the exchange rate.
I highlighted at the outset the commitment adopted by many leading nations to
set monetary policy to achieve domestic objectives such that the exchange rate would not
be a primary consideration in the setting of monetary policy. In the case that balancesheet and conventional monetary policies have equivalent effects on both domestic
spending and the exchange rate, this common principle is straightforward. But if the
cross-border spillovers of reductions in the balance sheet and increases in the policy rate
are not equivalent, the sequencing of policy rate and balance sheet normalization could
have important implications for the exchange rate and external balance.


This simulation is shown in figure 2 in the appendix.

- 10 Finally, in circumstances where a major central bank is continuing to expand its
balance sheet or maintaining a large balance sheet over a sustained period, this policy
would likely exert downward pressure on term premiums around the globe, especially in
those foreign economies whose bonds were perceived as close substitutes. Indeed, until
very recently, it had been notable how little long yields moved up in the United States
even as discussions of balance sheet normalization have moved to the forefront. This
likely reflects at least in part the expectation that ongoing asset purchase programs in
other advanced economies would continue holding down long-term yields globally. The
tide seems to have turned in recent weeks, as long yields in the U.S. have increased
notably on market perceptions that foreign officials are beginning to deliberate their own
normalization strategies.
I have used a simple stylized model to illustrate circumstances in which the
choice of normalization strategies adopted by major central banks can potentially be quite
consequential. If anything, the analysis presented here serves to highlight the importance
of research assessing this question from both an empirical and theoretical perspective.
Let me conclude by returning to the policy choices facing central banks. The
Federal Reserve chose to remove accommodation initially through increases in the
federal funds rate. In light of recent policy moves, I consider normalization of the federal
funds rate to be well under way. If the data continue to confirm a strong labor market
and firming economic activity, I believe it would be appropriate relatively soon to
commence the gradual and predictable process of allowing the balance sheet to run off.
Once that process begins, I will want to assess the inflation process closely before
making a determination on further adjustments to the federal funds rate in light of the

- 11 recent softness in core PCE (personal consumption expenditures) inflation. In my view,
the neutral level of the federal funds rate is likely to remain close to zero in real terms
over the medium term. If that is the case, we would not have much more additional work
to do on moving to a neutral stance. I will want to monitor inflation developments
carefully, and to move cautiously on further increases in the federal funds rate, so as to
help guide inflation back up around our symmetric target.
Meanwhile, in recent days, we have begun to hear acknowledgement from other
major central banks that they too are seeing conditions that suggest policy normalization
could be on the table before too long, against the backdrop of a brighter global outlook.
As I just discussed, the pace and timing of how central banks around the world proceed
with normalization, and the importance of balance sheet policy relative to changes in
short term rates in these normalization plans, could have important implications for
exchange rates and financial conditions globally.

- 12 -

Appendix: Description of Stylized Model and Simulation Results
A. Model Description
The model is a stylized open economy model that includes two symmetric
countries linked through trade flows. The model is specified in real terms under the
implicit assumption that inflation is constant (so that real and nominal variables move by
the same amount). Moreover, the model abstracts from any financial linkages between
the two economies, including the possibility that monetary policy actions in one country
could directly affect yields in the other (e.g., through portfolio balance channels), though
such effects are clearly important empirically.
The two countries include a “Home” (H) county and a “Foreign” (F) country of
equal size. Variables in the foreign country are denoted with an asterisk. In each
country, the national accounting identity specifies that output, y, is equal to the sum of
absorption d and net exports nx, that is:
y = d + nx,
y ∗ = d ∗ − nx,

where the second equation incorporates the global resource constraint that nx + nx* = 0.
Here output (y) and absorption (d) are expressed in percent deviation from their
respective steady states, while net exports are expressed as share of output, and are equal
to zero in the steady state (that is, prior to any shocks).

- 13 Home and foreign absorption depend on long–term interest rates according to the
following expressions:
d = −σ (rc + ru ) + u ,



d ∗ = −σ rc ∗ + ru ∗ + u ∗ ,

Here rc is the component of long–term interest rates that is driven by
conventional monetary policy, ru is the component of long–term interest rates that is
driven by unconventional monetary policy, and u is an exogenous aggregate demand
shock (with autocorrelation given by ρ). These interest rate components are assumed to
have identical effects on aggregate demand, with the parameter σ determining the
sensitivity of aggregate demand to either component (n..b., interest rates are expressed in
percentage points deviation from the steady state).
Net exports are assumed to fall if the real exchange rate (e) rises/appreciates, and
also if domestic demand is higher relative to foreign demand (since this boost imports).


nx = −ηe − α d − d ∗


where η is the elasticity of net exports with respect to the exchange rate, and α is the
elasticity of net exports to the differential between home and foreign absorption. The real
exchange rate is expressed in percent deviation from the steady state.
The exchange rate is determined according to an interest rate parity condition
which implies that the exchange rate appreciates when domestic interest rates are higher

- 14 than foreign interest rates, with elasticities ( φc and φu ) that can differ depending on
whether interest rate movements are driven by conventional or unconventional policy:





e = φc rc − rc ∗ + φu ru − ru ∗ .
The model is closed by specifying the behavior of the monetary authority. We
assume that the monetary authority can adjust either the interest rate associated with
conventional policy (rc), or the interest rate linked to balance sheet actions (ru), or both,
to affect output (its goal variable). The conventional feedback rule is thus:
rc = γ c y,
rc ∗ = γ c∗ y ∗ ,

whereas the unconventional feedback rule is:
ru = γ u y
ru ∗ = γ u∗ y ∗ .

The system above contains 10 equations in 10 endogenous variables (y, y*, d, d*,
nx, e, rc, rc*, ru, ru*), as well two shocks, u and u*, that can move GDP, its components,
exchange rates
B. Simulation Results
Figures 1 and 2 show the results of simulating the model under alternative
assumptions about the shocks and monetary policy reaction. In each case, the economy
starts in steady state with all variables at zero and experiences a demand shock in period
1 that dies out with an autocorrelation ρ of 0.95. All parameter values are reported in
Table 1.

- 15 Figure 1. Home Demand Shock
Figure 1 illustrates the case of a favorable demand shock in the home country.
The solid lines illustrate the case when Home uses the short-term interest rate as its active
policy tool, and keeps its balance sheet on hold, consistent with a desire to delay balance
sheet normalization.
The policy reaction is calibrated to be sufficiently aggressive that home GDP
always remains at baseline (see column 2 of Table 1). The higher policy rate path (that
is, higher rc) causes the long-term interest rate (panel A) to rise, which in turn induces the
real exchange rate to appreciate (panel B). The stronger currency and an expansion in
domestic absorption (panel C) causes a deterioration in net exports (panel D). At the end
of the period shown, domestic demand has nearly returned to baseline, while net exports
are just a bit below baseline--consistent with Home country’s GDP remaining at baseline
(panel E). Because foreign monetary policy rates is assumed to remain on hold, foreign
GDP (panel F) rises by the improvement in its net exports (that is, by the mirror image of
panel D, given that foreign domestic absorption is unchanged).
The dashed lines illustrate the case of a favorable demand shock in the Home
country when the central bank opts to tighten exclusively through reducing its balance
sheet (again, by enough to keep output at potential--see column 3 of Table 1). Long-term
interest rates (panel A) rise in response, but the exchange rate appreciates less in this case
(panel B), reflecting the lower assumed sensitivity of the exchange rate to unconventional
monetary policy actions (φu < φc ). Net exports decline (panel D) by less--reflecting both
the smaller exchange rate appreciation and a smaller rise in absorption (panel C)--which
translates into less of a boost to foreign GDP (panel F) than when the home country
adjusts through conventional policy.

- 16 Figure 2. Common Demand Shock, Asymmetric Policy Tightening across Countries
Figure 2 shows a simulation in which the demand shock is assumed to be
common across countries ( u = u* ). The home country is assumed to pursue a policy of
actively adjusting its policy rate, while the foreign Country is assumed to rely exclusively
on normalizing through the balance sheet. In each case, the central banks of the two
countries tighten policy aggressively enough to keep output at potential (see the
parameter settings in column 4 of Table 1).
As policy rates rise in the home country (panel A) and the exchange rate is more
sensitive to policy rates than to the balance sheet, the home country's exchange rate
(panel B) appreciates, while its net exports (panel D) decline. Although GDP remains at
baseline in each country (panels E and F) given our assumption that monetary policy
keeps output at potential (which is unchanged), the alternative policy normalization
choices clearly have important effects--even under a common shock--on both exchange
rates and the composition of demand in each country. In particular, because exchange
rates in the foreign country are less sensitive to balance sheet than to interest rate policy,
the foreign central bank must enact a relatively larger interest rate tightening in order to
keep its GDP at potential.

- 17 -

Table 1: Parameter Values

- 18 -

- 19 -

- 20 References
Alon, Titan, and Eric Swanson (2011). “Operation Twist and the Effect of Large-Scale
Asset Purchases,” FRBSF Economic Letter 2011-13. San Francisco: Federal
Reserve Bank of San Francisco, April 25,
Bowman, David, Juan M. Londono, and Horacio Sapriza (2015), “U.S. Unconventional
Monetary Policy and Transmission to Emerging Market Economies," Journal of
International Money and Finance, vol. 55 (July), pp. 27-59.
Brainard, Lael (2015a). "Unconventional Monetary Policy and Cross-Border Spillovers,"
speech delivered at "Unconventional Monetary and Exchange Rate Policies," the
16th International Monetary Fund Jacques Polak Research Conference, sponsored
by the International Monetary Fund, Washington, November 6,
Brainard, Lael (2015b), “Normalizing Monetary Policy When the Neutral Interest Rate is
Low,” speech delivered at the Stanford Institute for Economic Policy Research,
Stanford, Calif., December 1,
Ferrari, Massimo, Jonathan Kearns, and Andreas Schrimpf (2016). “Monetary Shocks at
High-Frequency and Their Changing FX Transmission around the Globe,”
Glick, Reuven, and Sylvain Leduc, (2015). “Unconventional Monetary Policy and the
Dollar: Conventional Signs, Unconventional Magnitudes,” Federal Reserve Bank
of San Francisco Working Paper Series 2015-18, November,
Hofmann, Boris, Ilhyock Shim, and Hyun Song Shin (2016). “Risk-Taking Channel of
Currency Appreciation,” BIS Working Paper No. 538. Basel, Switzerland: Bank
for International Settlements, January (revised May 2017),
Modigliani, Franco, and Richard Sutch (1966). “Innovations in Interest Rate Policy,”
American Economic Review, vol. 56 (March), pp. 178-97.
Rey, Hélène (2014). International Channels of Transmission of Monetary Policy and the
Mundellian Trilemma,” paper presented at the 15th Jacques Polak Annual
Research Conference, sponsored by the International Monetary Fund,
Washington, November 13-14,

- 21 Ross, Myron H. (1966), “ ‘Operation Twist’: A Mistaken Policy?” Journal of Political
Economy, vol. 74 (April), pp. 195-99.
Stavrakeva, Vania, and Jenny Tang (2016). “Exchange Rates and the Yield Curve,”
Research Department Working Papers 16-21. Boston: Federal Reserve Bank of
Boston, April,
Stein, Jerome L. (1965). “International Short-Term Capital Movements,” American
Economic Review, vol. 55 (March), pp. 40-66.
Swanson, Eric T. (2017). “Measuring the Effects of Federal Reserve Forward Guidance
and Asset Purchases on Financial Markets,” NBER Working Paper 23311.
Washington: National Bureau of Economic Research, April (revised June).