Pimco: Global Fetters

August 26, 2019

While Fed Chair Jay Powell’s speech at Jackson Hole this week didn’t break any new ground other than confirming market pricing for further near-term rate cuts, several academic papers presented at the Jackson Hole symposium and Bank of England Governor Mark Carney’s luncheon speech provided deeper insights into global monetary linkages that have become an increasing headache for central bankers both in the U.S. and elsewhere. I won’t be able to do justice to all of these contributions in this brief email and would encourage you to take a look at the contributions yourself if you manage to take your eyes off twitter for a while (tough, I know!), but here are my main takeaways.

Some historical perspective first: Largely thanks to UC Berkeley scholar Barry Eichengreen’s work culminating in his masterful 1992 book Golden Fetters: The Gold Standard and the Great Depression, 1919-1939, it is widely understood how the international gold standard, as reconstructed after World War I, constrained domestic monetary policies in the participating countries, transmitted destabilizing influences from the United States to the rest of the world in the late 1920s, and helped set the stage for the Great Depression of the 1930s.

Obviously, no such rule-based constraints for monetary policy exist in today’s international monetary system of fiat currencies and flexible exchange rates. So, in theory, central banks are free to pursue domestic monetary policy independently of each other in their pursuit of domestic stability. 

In reality, however, central banks today increasingly face other limitations: The institutional “golden fetters” of the interwar period have been replaced by fundamental “global fetters” that severely constrain monetary policy.

These shackles reflect (i) the role of the U.S. dollar as the dominant international currency and (ii) the increasing influence of the global equilibrium interest rate (r*) on domestic r*.  Unlike the “golden fetters”, the “global fetters” are unlikely to cause a Great Depression, but they have the potential to act as a further drag on both the global and the U.S. economy, particularly if the Fed does not take them sufficiently into account fast enough.

Several of the Jackson Hole papers as well as Mark Carney’s speech (all of which can be accessed here) document the economic and financial spillovers created by U.S. interest rate and dollar cycles on the rest of the world. These spillovers are much larger than the (falling) share of the U.S. economy in global GDP would suggest because the U.S. dollar remains the dominant currency in international trade, security issuance and holdings, and foreign exchange reserves. The magic number here is two-thirds: Two-thirds of global securities issuance and official fx reserves are denominated in U.S. dollars, two-thirds of EM external debt is denominated in U.S. dollars, and the dollar serves as the monetary anchor in countries accounting for two-thirds of global GDP (see Mark Carney’s speech for references).

As a consequence, the global financial cycle is in reality a U.S. interest rate and U.S. dollar cycle. Last year’s developments were a case in point: The strain from rising U.S. interest rates and a strong dollar caused major breakage in many EM economies, especially those where dollar-denominated debt plays a large role,  and, along with the escalating trade war, led to a sharp slowdown in the global trade and manufacturing cycle that is still playing out. Increasingly, the U.S. data – exports, business investment, corporate earnings, manufacturing output, and (following the large benchmark revisions this past week) payrolls – show clear signs of the spillovers of U.S. policy to the rest of the world creating significant spillbacks into the U.S. economy. 

However, the proverbial buck doesn’t stop here. The other major reason for why “global fetters” increasingly constrain monetary policy even in the issuer country of the world’s dominant currency is what could be called the increasing dominance of the global equilibrium interest rate, r*. The Jackson Hole paper by San Francisco Fed economist Oscar Jorda and UC Davis professor Alan Taylor (who is also a senior advisor to PIMCO) documents that monetary policy in the major economies has been predominantly driven by the “stars”, i.e. the slow-moving and generally falling global and domestic natural interest rates, that developments across these economies have become more synchronized over the past few decades and that, to quote the title of the paper, central banks are now “riders on the storm” of these global developments.

The good news is that, for some time now, the Fed has recognized and increasingly acknowledges the importance of global spillbacks and falling global r* as a consequence of global excess savings for U.S. economic outcomes and monetary policy. Accounting for these global factors, the lack of inflation pressures despite a 50-year low in the unemployment rate, as well as the current yield curve inversion (as longer-term interest rates are heavily influenced by globally low or negative rates) are much less puzzling than U.S. domestically-focused commentators tend to claim.

The bad news, however, is, that despite their awareness and acknowledgement of these global factors, Fed policy makers still risk lagging behind what looks like a rapidly falling global and domestic r* resulting from global political uncertainty and the likely severe hit to global and U.S. potential growth from a rapidly accelerating trade and technology war between the U.S. and China.

To be sure, this is not a criticism of the Fed – it is simply hard for everyone to keep up with developments on the trade war and twitter these days, and committees like the FOMC need some time to forge a consensus on the implications and the appropriate (in my view, much more aggressive) response. In the meantime, however, hobbled by global fetters, the stars keep falling.