Further Evidence on the Fed's Superpower Status

I have made the case many times that the Federal Reserve is a monetary superpower. The Fed has this power because it manages the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. As a result, its monetary policy gets exported to much of the emerging world. The ECB and Bank of Japan are also influenced by the Fed's decisions because they are careful not to let their currencies becomes too expensive relative to these dollar-pegged currencies and the dollar itself.  U.S. monetary policy, consequently, gets exported to the Eurozone and Japan as well.  

This understanding helps explains why there was a global liquidity glut during housing boom period and suggests that some of the "global saving glut" was simply a recycling of loose U.S. monetary policy.  It also implies that the Fed could now do a lot of good for both the U.S. and Eurozone economies if were to adopt something like a NGDP level target.  Based on this view, the global economy sorely needs the Fed to wake up from its slumber. Fed Chairman Ben Bernanke admitted as much in one of his classroom lectures earlier this year.¹

Chris Crowe and I developed this monetary superpower hypothesis in a paper that is now in my newly published book. In a new paper, Colin Gray has gone even further by formally motivating this hypothesis in a rational expectations model.  He also has provided more robust empirical evidence for it.  Here is his abstract:

Between 2002 and 2006, the United States Federal Reserve set interest rates significantly below the rates suggested by well-known monetary policy rules. There is a growing body of research suggesting that this helped fuel an excess of liquidity in the U.S. that contributed to the 2008 worldwide financial crash. What is less well known is that a number of other central banks also lowered interest rates during this period. An important question, then, is what role the Federal Reserve played in influencing other central banks to alter their own monetary policies, which could have magnified the Fed’s actions in creating global liquidity. This paper addresses the issue by showing how spillovers in central bank behavior occur in theoretical rational expectations models. It then establishes empirically how U.S. monetary policy actions affect the actions of other major central banks, particularly in terms of interest rates and currency interventions. The data suggest that the U.S. lowering its policy rate, in general or in reference to a specific monetary policy rule, influences other central banks to lower their own policy rates and intervene in currency markets, even when controlling for worldwide macroeconomic trends. Finally, this paper shows that spillovers from U.S. actions are partially responsible for the worldwide lowering of interest rates and the increase in currency reserves in the early 2000’s that may have contributed to the subsequent worldwide liquidity boom.

The findings of this paper deserve further discussion.  In particular, how should the Fed operate given it has this monetary superpower status?  Is there a way to do U.S. monetary policy that maximizes macroeconomic stability for both the United States and the rest of the world?  These are important questions that will become more important over time as the global economy continues to integrate. 

¹Okay, he really did not admit it, but it was implied in his acknowledgement that Chinese monetary policy is influenced by U.S. monetary policy.