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February 26, 2016

What Happened to the Great Divergence?

Remarks by
Lael Brainard
Board of Governors of the Federal Reserve System
“2016 Monetary Policy Forum”
An annual conference sponsored by
University of Chicago Booth School of Business
New York, New York

February 26, 2016

Beginning in 2014, we saw confident predictions of a coming strong divergence
in monetary policy among the major economies. To date, there has been less policy
divergence in reality than had been predicted. This observation raises the question of
whether there may be limits on policy divergence in current circumstances. Such limits
might reflect common forces buffeting economies around the world or the powerful
transmission of shocks across borders through exchange rate and other financial channels
that may have the effect of front-running monetary policy adjustments in the vicinity of
the zero lower bound. Put differently, predictions that U.S. monetary policy would chart
a notably divergent path have been tempered by powerful crosscurrents from abroad. 1
How Different Are Underlying Conditions?
Before turning to divergences in policy, it is useful to review briefly the extent of
differences in the underlying economic conditions in the major advanced economies.
While the recovery from the global financial crisis has been frustratingly slow in every
major economy, there nonetheless have been important differences in the pace and extent
of healing. Speaking loosely, among the advanced economies, the United States and
United Kingdom appear farthest along in closing resource gaps, Japan is next in line, and
the euro area has been somewhat slower to recover. In the United States, resource
utilization has increased substantially over the past five years. The U.S. unemployment
rate is now under 5 percent, compared with 10 percent at its recent peak. Even so, there
is evidence that some labor market slack still remains. 2 The United Kingdom has
experienced a rapid drop in unemployment to 5.1 percent, as low as pre-crisis levels, and


These remarks represent my own views, which do not necessarily represent those of the Federal Reserve
Board or the Federal Open Market Committee.
The employment-to-population ratio for prime-age individuals, for example, is nearly 2 percentage points
below its 2004-07 average, while part-time work remains elevated and progress on wages has been slow.

-2 labor force participation has remained relatively strong. In contrast, unemployment in the
euro area was 10-1/2 percent in the fourth quarter, down just 1-3/4 percentage points
from its recent peak and still well above pre-crisis levels. Accordingly, market
participants have expected policy in the United States and the United Kingdom to
become less accommodative, while remaining very accommodative over the medium
term in the euro area. 3
In Japan, expectations of monetary policy divergence have reflected Japan’s long
period of disappointments on its inflation target to a greater extent than its remaining
resource gap. Japan’s unemployment rate is 3.3 percent, already below the previous
cyclical trough, and the International Monetary Fund estimates the output gap to have
been the same in Japan and the United States in 2015 at 1-1/2 percent. However, with
inflation in Japan previously having been near zero for an extended period and inflation
expectations under pressure, the Bank of Japan’s commitment to increasing inflation
expectations and moving inflation up to its 2 percent target has led market participants to
expect extremely accommodative monetary policy to persist for quite a while.
Currently, however, there are smaller differences among the major economies on
measures of realized and expected inflation than there are on resource utilization. In
2015, the 12-month change in total personal consumption expenditures (PCE) inflation in
the United States was 0.6 percent, while headline inflation in the United Kingdom, euro
area, and Japan were 0.2 percent. All inflation rates are well below target. Of course, to
the extent that the downward pressure on global inflation is due to falling oil prices, this
pressure would be expected to abate if oil prices stabilize.


See p. 24 of the February 2016 Monetary Policy Report (Board of Governors, 2016).

-3 But even after removing energy prices, core PCE inflation has come in
consistently under the Federal Reserve’s 2 percent target here in the United States and
does not look very different from inflation in economies that are expected to maintain
accommodative monetary policy for some time. Core PCE inflation, or inflation
excluding food and energy prices, has remained stubbornly in the vicinity of 1-1/4 to 11/2 percent over the past three years in the United States, similar to the United Kingdom
and not very different from the roughly 1 percent core inflation in the euro area and
We also see notable similarities in the recent deterioration in market measures of
inflation expectations. While in the euro area, swaps-based inflation compensation has
fallen about 3/4 percentage point since the middle of 2014 and is now around 1-1/2
percent at the five-year, five-year-ahead horizon, in the United States, swaps-based
inflation compensation has fallen 1 full percentage point over the same period and is now
at 1-3/4 percent. Japan has experienced a similar decline over this period, while the
United Kingdom has seen a much more modest decline.
With realized and expected future inflation not showing large differences, the
expectation of monetary policy divergence between the United States, on the one hand,
and the United Kingdom and the euro area, on the other, must rest to a large extent on
remaining differences in resource utilization and expectations that inflation outcomes will
diverge as a result of these differences. However, it is important to note that the extent of
inflation divergence generated by differences in resource utilization across countries is
likely much smaller now than it has been in earlier decades. Recent research suggests a

-4 dramatic flattening of the Phillips curve in recent decades. 4 If this finding continues to
hold true, resource utilization would need to differ more sharply across national
economies to produce a noticeable difference in inflation.
The persistence of relatively soft core PCE inflation readings in the United States,
despite a substantial improvement in employment, suggests we should be cautious in
relying on the historical relationship between employment gains and stronger inflation in
today’s economy. Moreover, the softening in market-based measures of inflation
expectations and some hints of weakening in survey measures deserve our attention. This
deterioration in inflation expectations and a weakened link between labor market
tightening and inflation--together with the asymmetry of policy in the vicinity of the
lower bound--lead me to put a high premium on evidence that actual inflation is firming
Putting these pieces of evidence together suggests that if core inflation remains
below target in all major advanced economies and inflation expectations remain under
pressure in many, I might expect policy divergence to remain more limited than
previously predicted.
Common Conditions
To the extent that we are observing limited divergence in inflation outcomes and
less divergence in realized policy paths than many anticipated, this could be attributable
to common shocks or trends that cause economic conditions to be synchronized across
economies. The sharp repeated declines in the price of oil have been a major common


In the United States, for example, Blanchard (2016) estimates that the slope of the Phillips curve has
declined by more than two-thirds since the 1970s. Other recent research includes Blanchard, Cerutti, and
Summers (2015) and Kiley (2015b).

-5 factor depressing headline inflation and are also likely feeding into low core inflation,
although to a lesser extent. 5 As noted previously, these price declines have led headline
inflation across the globe to behave quite similarly over this time period. Even so, most
observers expect this source of convergence in inflationary outcomes to eventually fade
and thereafter not affect monetary policy paths over the medium term.
In contrast, a more persistent source of convergence may be found in an apparent
decline in the neutral rate of interest. The neutral rate of interest--or the rate of interest
consistent with the economy remaining at its potential rate of output and inflation
remaining at target level--appears to have declined over the past 30 years in the United
States and is now at historically low levels. 6 Similarly, longer-run interest rates appear
also to have fallen across a broad group of advanced and emerging market economies,
suggesting that neutral rates are at historically low levels in many countries around the
world and near or below zero in the major advanced foreign economies. 7 Although the
reasons for the declines in neutral rates are not perfectly understood and may differ across
countries, there are some common drivers, such as slower productivity and labor force
growth and a heightened sensitivity to risk. 8

In five of the six quarters since mid-2014, the price of oil has decreased for a cumulative decline of
70 percent.
See Brainard (2015b), Hamilton and others (2015), Kiley (2015a), Laubach and Williams (2015), and
Johannsen and Mertens (2016).
See Hamilton and others (2015), Del Negro and others (2015), and chapter 3 of World Economic Outlook
(International Monetary Fund, 2014).
While the empirical link between potential growth and the neutral rate is not precisely estimated, the
evidence suggests that slower trend growth is associated with lower interest rates; see Laubach and
Williams (2015) and Hamilton and others (2015). U.S. labor force growth has slowed from 1 percent from
2001 to 2004 to 1/2 percent over the most recent 4 years. Over the same periods, euro-area growth has
slowed from 1.3 percent to 0.4 percent. In Japan the labor force was essentially flat from 2011 to 2015,
though this was a slight improvement from a small rate of decline in the early 2000s. Productivity growth
over the same periods has slowed from 3.0 percent to 0.5 percent in the United States, from 0.6 percent to
0.2 percent in the euro area, and 1.5 percent to 0.5 percent in Japan.

-6 The very low levels of the shorter run neutral rate reflect in part headwinds from
the crisis that are likely to dissipate over time. However, if many of the common forces
holding down neutral rates prove persistent, then neutral rates may remain low through
the medium term, implying a shallower path for policy trajectories.
The global economy is also experiencing a downshift in emerging market growth
momentum led by China, which may prove somewhat persistent. Whereas earlier in the
recovery there was a striking divergence between the relatively buoyant growth in major
emerging economies and depressed growth in advanced economies, lately the extent of
divergence has diminished noticeably. 9 China is undergoing a challenging set of
economic transitions. Trend growth has slowed substantially and is expected to slow
further, and the composition of growth is shifting away from resource-intensive
manufacturing and exports toward a greater share for consumption and services. China’s
investment has slowed sharply recently after accounting for nearly one-third of global
investment over the past three years and about one-half of global consumption in certain
metals such as iron ore, aluminum, copper, and nickel. Commodity exporters and close
trading partners in Asia will be most affected, but the changes in the composition and rate
of growth in a country that has accounted for about one-third of the growth in world
output and trade will likely ripple through the global economy much more generally.

Regarding sensitivity to risk, the risk premium for capital investment appears to have increased since
the crisis; see Del Negro and others (2015). A higher risk premium requires a lower risk-free rate to
generate an equivalent level of investment.
From the end of 2009 to the end of 2013, growth in important U.S. emerging market trading partners
averaged 4.7 percent, while growth in advanced economies averaged 1.8 percent. However, in 2014
emerging country growth slowed to 3.3 percent, compared with 1.6 percent in advanced economies, and for
the first three quarters of 2015, annualized growth was 2.5 percent and 1.1 percent, respectively.

-7 Amplified Spillovers
Of course, policy divergence among major economies could be limited by rapid
and strong transmission of foreign shocks across borders. In particular, although the U.S.
real economy has traditionally been seen as more insulated from foreign trade shocks
than many smaller economies, the combination of the highly global role of the dollar and
U.S. financial markets and the proximity to the zero lower bound may be amplifying
spillovers from foreign financial conditions. By one rough estimate, accounting for the
net effect of exchange rate appreciation and changes in equity valuations and long term
yields, over the past year and a half, the United States has experienced a tightening of
financial conditions that is the equivalent of an additional increase of over 75 basis points
in the federal funds rate. 10
The transmission of divergent economic conditions across borders typically
occurs though a couple of different channels. First, a decline in demand in one country
reduces its demand for imports from other countries. Second, the fall in economic
activity would be expected to trigger a more accommodative monetary policy, which
helps offset the effect of the shock by both supporting domestic demand and weakening
the exchange rate. The weaker exchange rate in turn leads domestic consumers to switch
their expenditures away from more expensive foreign imports to cheaper domestic
products while increasing the competitiveness of exports. The extent to which monetary
policy offsets the shock by dispersing it to trade partners as opposed to strengthening

These estimates are based on rough rules of thumb regarding the effects on output of changes in longterm interest rates, equity prices, the exchange rate, and the federal funds rate from the FRB/US model and
assume a highly persistent change in the federal funds rate. Some private-forecaster estimates of financial
tightening--expressed in terms of the federal funds rate--are larger, which may reflect an assumption of a
less persistent funds rate change. An alternative estimate from the Federal Reserve Bank of New York’s
DSGE model, which explicitly includes a financial sector, suggests the tightening in financial conditions
since mid-2015 is equivalent to an increase in the federal funds rate of roughly 100 basis points.

-8 domestic demand depends on the responsiveness of domestic demand relative to the
exchange rate. The exchange rate channel, by raising the price of imports in domestic
currency, also pushes up domestic inflation and exerts downward pressure on foreign
The strength of spillovers across countries and the extent to which that affects
policy divergence across countries depend on a foreign economy’s openness to these
different channels. The recent experience of Sweden suggests that for highly open
economies, the effect of foreign shocks can be extremely powerful. 11 Sweden’s
economic growth has been relatively rapid recently, reaching nearly 4 percent over the
most recent four quarters. Moreover, the employment gap is estimated to be nearly
closed, and there are signs of financial excess in the housing market. In ordinary times,
these conditions would be consistent with relatively tight monetary policy. However,
inflation has run persistently well below the central bank’s 2 percent inflation target.
Given the relative openness of Sweden’s economy, moving the inflation rate back up to
target has been greatly complicated by the sensitivity of Sweden’s exchange rate and
financial conditions to developments in the euro area, where domestic economic
conditions are consistent with much more accommodative policy. As a result, the
Riksbank has been pursuing extremely accommodative monetary policy, most recently
lowering the interest rate on deposits to minus 0.5 percent and authorizing the Governor
and Deputy Governor to intervene in foreign currency markets.
Even in the much larger United States economy, with imports accounting for a
little over 15 percent of gross domestic product (GDP), spillovers can be quite strong, in


Imports and exports each account for a little under one-half of Sweden’s GDP.

-9 part reflecting the international role of U.S. financial markets and the dollar. Since the
middle of 2014, with a reassessment of demand growth in the euro area and subsequently
in emerging markets and other commodity exporters, the real trade-weighted value of the
dollar has increased nearly 20 percent. As a result, in 2014 and 2015, net exports
subtracted a little over 1/2 percentage point from GDP growth each year, and
econometric models point to a subtraction of a further 1 percentage point this year. 12 In
addition, the dollar’s appreciation is estimated to have put significant downward pressure
on inflation: Non-oil import prices fell 3-1/2 percent in 2015, subtracting an estimated
1/2 percentage point from core PCE inflation. 13
Financial channels can powerfully propagate negative shocks in one market by
catalyzing a broader reassessment of risks and increases in risk spreads across many
financial markets. Since the beginning of the year, U.S. financial markets have reacted
strongly to adverse news on emerging market growth, even though the news on the U.S.
labor market has remained positive. In this regard, although China’s direct imports from
the United States are modest, uncertainty about changes to its exchange rate system and
financial imbalances, together with changes in the composition of its growth, have had
broader global spillovers that may pose risks to the U.S. outlook.
Recent events suggest the transmission of foreign shocks can take place extremely
quickly such that financial markets anticipate and indeed may thereby front-run the
expected monetary policy reactions to these developments. It also appears that the
exchange rate channel may have played a particularly important role recently in
transmitting economic and financial developments across national borders. Indeed,


See Gruber, McCallum, and Vigfusson (2016).
See pp. 8-9 of the February 2016 Monetary Policy Report (Board of Governors, 2016).

- 10 recent research suggests that financial transmission is likely to be amplified in economies
with near-zero interest rates, such that anticipated monetary policy adjustments in one
economy may contribute more to a shifting of demand across borders than a boost to
overall demand. 14 This finding could explain why the sensitivity of exchange rate
movements to economic news and to changes in foreign monetary policy appear to have
been relatively elevated recently.
Financial tightening associated with cross-border spillovers may be limiting the
extent to which U.S. policy diverges from major economies. As policy adjusts to the
evolution of the data, the combination of heightened spillovers from weaker foreign
economies, along with a lower neutral rate, could result in a lower policy path in the
United States relative to what many had predicted.
In circumstances where many economies face common negative shocks or where
negative shocks in one country are quickly transmitted across borders, it is natural to
consider whether coordination can improve outcomes. Under certain conditions--such as
flexible exchange rates, deep and well-regulated financial markets, and flexible product
and labor markets--policies designed for the domestic economy can readily offset any
spillovers from economic conditions abroad, and policies designed to address domestic
conditions can achieve desirable outcomes both within the national economy and more
broadly. 15
In some circumstances, however, cooperation can be quite helpful. If, for
example, economies face a common challenge, coordination can communicate to markets


See Caballero, Farhi, and Gourinchas (2015).
See Brainard (2015a).

- 11 that policymakers recognize the challenge and will work to address it. Reducing
uncertainty about the direction of policy and addressing concerns about policies working
at cross-purposes can boost the confidence of businesses and households. With
intensified transmission effects in the vicinity of the zero lower bound, there is a risk that
uncoordinated policy on its own could have the effect of shifting demand across borders
rather than addressing the underlying weakness in global demand. The difficult start to
the year should be a prompt for greater policy coherence and clarity. This might be a
good time for policymakers to reaffirm their commitment to work toward the common
goal of strengthening global demand.
Similarly, with anemic global demand and interest rates near zero, in some
economies there is scope for monetary policy to be more effective with fiscal policy
working in the same direction. With potential growth and nominal borrowing rates both
low, public investment that increases potential in the longer run and demand in the
shorter run could make an important contribution. A joint determination by policymakers
across major economies to better deploy policy tools to provide support for global
demand could be beneficial.

- 12 References
Blanchard, Olivier (2016). “The U.S. Phillips Curve: Back to the 60s?” Policy Brief
PB16-1. Washington: Peterson Institute of International Economics, January,
Blanchard, Olivier, Eugenio Cerutti, and Lawrence Summers (2015). “Inflation and
Activity--Two Explorations and Their Monetary Policy Implications,” NBER
Working Paper Series 21726. Cambridge, Mass.: National Bureau of Economic
Research, November,
Board of Governors of the Federal Reserve System (2016). Monetary Policy Report.
Washington: Board of Governors, February,
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,
--------- (2015b). “Normalizing Monetary Policy When the Neutral Interest Rate Is
Low,” speech delivered at Stanford Institute for Economic Policy Research,
Stanford, Calif., December 1,
Caballero, Ricardo J., Emmanuel Farhi, and Pierre-Olivier Gourinchas (2015). “Global
Imbalances and Currency Wars at the ZLB,” NBER Working Paper Series 21670.
Cambridge, Mass.: National Bureau of Economic Research, October,
Del Negro, Marco, Marc Giannoni, Matthew Cocci, Sara Shahanaghi, and Micah Smith
(2015). “Why Are Interest Rates So Low?” Federal Reserve Bank of New York,
Liberty Street Economics (blog), May 20,
Gruber, Joseph, Andrew McCallum, and Robert Vigfusson (2016). “The Dollar in the
U.S. International Transactions (USIT) Model,” IFDP Notes. Washington: Board
of Governors of the Federal Reserve System, February 8,
Hamilton, James D., Ethan S. Harris, Jan Hatzius, and Kenneth D. West (2015). “The
Equilibrium Real Funds Rate: Past, Present, and Future,” NBER Working Paper
Series 21476. Cambridge, Mass.: National Bureau of Economic Research,

- 13 International Monetary Fund (2014). “Perspectives on Global Real Interest Rates,”
chapter 3 in World Economic Outlook: Recovery Strengthens, Remains Uneven.
Washington: IMF, April, pp. 81-112,
Johannsen, Benjamin K., and Elmar Mertens (2016). “The Expected Real Interest Rate
in the Long Run: Time Series Evidence with the Effective Lower Bound,” FEDS
Notes. Washington: Board of Governors of the Federal Reserve System,
February 9,
Kiley, Michael T. (2015a). “What Can the Data Tell Us about the Equilibrium Real
Interest Rate?” Finance and Economics Discussion Series 2015-077.
Washington: Board of Governors of the Federal Reserve System, August,
--------- (2015b). “Low Inflation in the United States: A Summary of Recent Research,”
FEDS Notes. Washington: Board of Governors of the Federal Reserve System,
November 23,
Laubach, Thomas, and John C. Williams (2015). “Measuring the Natural Rate of Interest
Redux,” Working Paper Series 2015-16. San Francisco: Federal Reserve Bank of
San Francisco, October,