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of sEei Ä ry on delivery Dndon Time E.S.T. ) , 1990 Monetary Policy In An Inteqrated World Economy Address by Manuel H. Johnson Vice Chairman Board of Governors of the Federal Reserve System before Conference Sponsored by the Cato Institute London February 22, 1990 MONETARY POLICY IN AN INTEGRATED WORLD ECONOMY It is a pleasure to give the opening address at this Cato Conference focusing on the Global Monetary Order. Given the revolutionary changes in Europe and elsewhere, the theme of this conference is quite timely and appropriately broad-based: monetary policy, international financial markets, the regulation of as well as world monetary reform are all on the agenda. As the conference program states, "the globalization process raises a number of questions, one of the most important being how to achieve monetary stability in an integrated world economy." This morning, I would like to specifically address this issue. In particular, I want to talk about the formulation and implementation of monetary policy by central banks in a more deregulated, more globally integrated financial system. 2 Perhaps I should begin by describing the nature of the current monetary regime and some of the key factors shaping today's more dynamic economic and financial systems. The major trading regions of the world generally operate under a fiat money/flexible exchange rate regime. Admittedly, currency arrangements appear to be evolving into a system of multi-polar, currency blocs. "flexible" is used advisedly; good deal of (largely occurred in recent years. little doubt that term There is little doubt that sterilized) Nonetheless, exchange the perhaps "dirty" or "managed" float would be more appropriate. a Thus, rates intervention has there also can be between major trading regions do move all too frequently and often by substantial magnitudes. Exchange rate movements certainly play a large role in the transmission of changes in monetary policy as well as in the balance Nonetheless, despite the reserve belief of payments holdings by some have that adjustment mechanism. actually reserve increased, holdings would 3 decline when exchange rates were allowed to float. In particular, the dollar continues to serve as a key reserve currency under current international monetary arrangements. As the theme of this conference indicates, we live in an increasingly system. integrated and deregulated Revolutions in telecommunications and financial information processing have dramatically lowered the costs of acquiring, disseminating, and processing information and undoubtedly have quickened the pace of the integration process. These revolutions fostered a host of financial innovations which in turn enabled price, geographic, of financial doing, these financial markets services to be advances promoted services and more which in generally function more efficiently. and product regulations readily circumvented. the turn the deregulation allowed entire both market of In so these financial system to 4 These developments have literally changed the world; no part of the world, not even the centrally planned economies, Indeed, has the escaped vast the effects improvements in of these the changes. workings of market-based systems underscored the increasing problems of centrally planned economies. The growing production of both information and knowledge has contributed to an increasingly complex world information and and decentralized made it ever knowledge and debate market-based are processing and by of conditions obvious its the 1930s more information and that very And, necessarily transmitting supply and demand is dispersed. socialist-calculation systems more nature, as the demonstrated, efficient about providing such relative incentives produce and distribute desired goods and services. at to 5 Characteristics of this Environment One environment money and important is the characteristic increasingly financial capital. large of and our current rapid Capital flows, flows for have increased dramatically in recent years. of example, Not only has the size of these capital flows increased, but such capital transfers occur more quickly; many financial adjustments or provisional payments instantaneously. continuously. settlements Furthermore, can now such Foreign exchange and occur virtually movements some futures occur markets, for example, operate 24 hours a day around the globe. While currency substitution has not been empirically important in the industrialized Nevertheless, it world has to already date, been this could recognized change. that these substantial capital flows may well be so potent that they now drive trade flows rather than the other way around. 6 Portfolio adjustments within national borders and between various domestic financial markets have also become large and rapid. Individuals and corporations can easily and quickly move huge sums of money and financial capital between various financial instruments and between financial markets. As illustrations, we need only mention the advent of various money market mutual funds or stock index futures and program trading. Another increasingly important integrated characteristic financial environment of an is that financial markets have become more interdependent and less separate and segmented. National economies are now more influenced by international factors as opposed to their more isolated character increasingly open of the economies economy is the world economy. past. and the All only economies are truly closed In this environment, prices of financial assets, traded goods, and interest rates have 7 become increasingly interrelated and can even move in unison depending on the exchange rate regime. For example, on October 19, 1987 we witnessed the virtual simultaneous and nearly instantaneous of world equity prices. Recently, inflation rates of many large industrial economies have desire for exchange "adjustment" rate tended to converge as stability has led to the more coordinated monetary policies. An implication of this characteristic is that the U.S. economy portion, of overwhelmingly World War II. significant increasingly the is global dominant a portion, economy player it albeit rather was a major than immediately the after Accordingly, the actions or policies of other players now has greater spillover effects on U.S. markets either through movements in the exchange rate or in other financial asset prices. Research has shown, for example, that the variability of exchange rates, prices, bond prices, and equity prices commodity has been significantly greater during the last several years relative to the earlier increased postwar volatility period. was the More result than of likely more efficient information processing and greater international integration variances combined with in this financial domestic monetary policy goals among industrial countries. Implications for Monetary Policy I believe there are several major monetary policy implications integration that we arise see implications relate to monetary policy today from and the in greater the degree future. of These (1) the appropriate data for use as indicators or guides, (2) the appropriate anchor for the system, and (3) the coordination of monetary policy. Appropriate Data for Use as Monetary Policy Indicators or Guides The information requirements of a monetary authority operating in the world today are monumental. In 9 order to changing that is conduct appropriate environment, central banks relevant, reliable, as continuously available. relates policies to the Since future, in must well such have as looking rapidly- information quickly monetary policy forward a and necessarily information is critical. Yet it is evident that we live in a complex world of vast information needs where knowledge is decentralized and highly disaggregated. Accordingly, mechanisms are needed that work to summarize or aggregate defused data in order to make it useful for policymakers. Since financial integration and deregulation have fostered timely large and and rapid accurate financial quantity elusive. Current flows of compilation variables measures of financial and have capital, measurement proven money, of such difficult particularly the and narrow transactions balances, have proven to be much less reliable than was earlier the case. 10 In a and cumbersome amounts of rapidly changing world, process quantity of data collecting is not the time consuming and compiling likely to be the large most effective way of summarizing and aggregating information or of obtaining timely and accurate data upon which to base policy decisions. Measures of capital are, after the quantity of money all, necessarily and based on financial samples. Accordingly, such quantity data are subject to revisions and rebenchmarks that can often be substantial. Also, sampling techniques take time so that there is an inherent lag in the reporting rapidly of today, such data. quantity Because measures financial are often flows outdated move and sometimes fully obsolete by the time they are compiled and published. Measures of international financial capital movements, for example, are both notoriously inaccurate and sometimes published only months after they occur. 11 But international money and capital flows are not the only difficult forms to of financial measure. The flows which proliferation are of now more transactions instruments associated with deregulation, together with the ease of portfolio adjustments, has rendered the measurement of various domestic financial variables difficult as well. It is well known, for example, that the accurate measurement of narrow part transactions because of such balances has measurement defined monetary aggregates proven illusory. difficulties, (such as Ml) In narrowly have become much less useful as guides to monetary policy than was earlier the case. But there are still other problems with quantity data. To be useful, seasonally adjusted. for example, quantity data must be And should redefinitions of variables occur, due, for example, to deregulation, technological, or institutional developments, the altered measurements and changed behavior of particular variables can be substantial. 12 In sum, there are significant measurement, timing, and sometimes definitional problems associated with the use of sample-based rapidly quantity changing and data, particularly increasingly in our integrated current financial system. Price data, however, specifically price data from centralized auction markets such as bond, foreign exchange, and commodity markets, as policy today. guides, have a number of advantages for use especially in the fast paced world of To understand why this is the case, it is useful to remember that financial market aggregators of information prices are summaries of embodying the knowledge or and expectations of large numbers of buyers and sellers who have incentives to make informed decisions in an uncertain world. Active competitive markets are a mechanism that efficiently absorbs and processes dispersed information. As a consequence of this property, financial market prices (such as exchange rates, commodity prices, and 13 bond prices) provide useful information. Furthermore, they are timely and readily available literally by the minute. They are accurate, less subject to sampling error, and are not subject to revisions, rebenchmarks, seasonal adjustments or "shift-adjustments" that often plague quantity data. Since future, they market are prices inherently embody expectations forward looking, of the offering distinct advantage over any form of quantity data. a This is a particularly important quality for monetary policymakers who necessarily must be forward looking in their decisions. Because looking, they expectations. policy to be financial contain market prices information are about forward inflation For example, if the markets consider monetary too easy, based on the observations of thousands of traders, commodity prices and bond rates will be bid up to command an inflation premium and the exchange rate will depreciate to account for the reduced purchasing power of the currency. 14 In addition to being useful in the normal conduct of monetary policy, market price indicators are also quite useful for monetary authorities in financial crises when lender of last resort responsibilities become relevant. is in these circumstances that many It forms of monetary or reserve aggregates often prove particularly misleading for two important change Demands reasons. quickly for and First, demands dramatically currency, excess in for such reserves, liquidity circumstances. and other assets, for example, often increase sharply. can quality In this case, the quantity of reserves or narrow transactions aggregates can often changes prove in misleading demand for literally by the hour. guides these to policy. instruments In such situations, often Second, occur quantity data are obsolete by the time they are compiled or published. Market price data, however, are readily available literally by the minute. Lender-of-last resort policy decisions during a financial crisis necessarily must be made 15 very quickly. The data essential to support such decisions, therefore, must be readily available and timely. data (such as the monetary or reserve Quantity aggregates) are ill-suited for these circumstances whereas market price data are eminently appropriate. Sharp decreases in Treasury bill and bond yields, for example, could signal a flight to quality as well as work to flatten or invert the fed funds/Treasury bond yield spread. depending And dollar depreciation or appreciation could occur on financial the national crisis. immediately signal In the or international short, need key for an nature market of the prices increased may supply of Central Bank liquidity; these prices may provide correct and timely signals to the Central Bank in such Other market price data such stocks, even gold prices and as "quality may also circumstances. spreads," yield information on a timely basis in such circumstances. bank useful 16 In an analogous manner, market price data may prove useful by yielding timely and accurate information in the transition to a monetary union as is currently being contemplated by the German authorities. German long-term interest rates Movements as well mark exchange rates and commodity prices, suggest whether accommodating the supply rapidly of changing money in West as both Deutsche for example, and demands may reserves for DM in is a noninflationary manner. An Appropriate Monetary Anchor Another institutional Under any important arrangements fiat money just discussed stabilization objective. nominal bond yields general weakening in relates flexible nominal anchor is essential. guides implication to of current a monetary exchange rate anchor. regime, a Accordingly, the market price should be linked to a price For example, any sustained rise in and commodity prices the exchange combined with rate would very a likely 17 signal rising inflation expectations. This would suggest to the central bank a need for higher call money rates to avoid a future increase in the general price level. Such policy adjustments would be continually monitored against evidence of general price stabilization ultimate anchor to the system. which would provide the Of course, it is essential that this objective should be both an announced and credible goal. Since inflation is positively correlated with increased volatility in financial markets, policies aimed at producing a stable price environment will likely contribute to ensuring otherwise be that the such volatility case. Also, it is lower is important than would that price stabilizing monetary policies become the common objective of the major toward the industrialized goal of countries; price coordination stability can significantly to reduced volatility of exchange other relative financial market prices. efforts contribute rates and 18 Coordinated Monetary Policy Action It is also becoming obvious that in our increasingly integrated global financial system, the goal of price stabilization cannot be effectively achieved in isolation without significant changes in exchange rates and possibly the balance of payments. Whether we like it or not, cooperation among the major economies becomes more and more important volatility in and order to avoid potentially extreme disruptive financial shifts in international capital flows. As a consequence, central bank policies designed to coordinate price stabilization across countries deserve strong support. appropriate. flexibility Nonetheless, In to particular, insulate flexibility countries themselves is should from still have the irresponsible policies pursued elsewhere as well as from external shocks. Otherwise, such transmitted across major countries. shocks or policy bond markets and mistakes could stock markets of be all However, since movements in exchange rates 19 now play such an monetary policy, important role in the transmission they cannot be ignored. of And coordinating monetary policies with a price stability anchor should go a long way toward reducing excessive exchange rate volatility. Conclusion Monetary policymakers operate under a fiat money roughly flexible environment can deregulated exchange be global rate regime. characterized financial system as The an where current integrated, information is dispersed and decentralized. This continuous environment adjustments of produces money large, and rapid, financial and capital. Increased economic integration means that domestic financial markets have become much more sensitive to international forces. There are several important policy implications of these developments. price information The many advantages of financial market suggest that these prices are more 20 appropriate variables. fiat money, because the for use as policy A price stability flexible exchange world is guides than quantity anchor is essential under rate regime. becoming And, increasingly coordinated monetary policy action is desirable. a finally, integrated,
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