The visible hand in economics

Externalities and Fed monetary policy

Posted on: March 12, 2008

An interesting article by Sebastian Mallaby discussed the contrary monetary policy strategies of the US Federal Reserve (cut rates to avoid a recession) and the European Central bank (keep rates elevated to avoid inflation). (h.t. Greg Mankiw)

In the article, Mallaby alludes to the view that the US Federal Reserve might feel that it is the greater protector of the world economy – this takes for granted the positive externalities to the rest of the world from the Fed cutting rates. These are:

  1. A weakening of the US dollar – helping to stem inflationary pressures,
  2. Keeping demand for products elevated in the US – helping to keep demand (and prices) for other countries exports elevated.

The first possible positive externality is likely to be relatively weak for a number of countries – given that this only reduces tradable inflation insofar as it reduces the prices of goods imported from the US.

The second possible positive externality is the result of the inter-relationship between the US economy and the rest of the world. The US is the world consumer. As a result, domestic demand in the US does have an impact on the world price of goods – and the total quantity sold.

These externalities suggest that the Fed, if only acting in the interest of the US would under-cook interest rate cuts, and as a result we should be glad they are slashing rates with ‘reckless abandon’.

Of course this isn’t the whole story – there are negative externalities from the Fed’s decision:

  1. A weak US dollar implies makes foreign exporters less competitive, reducing the price they can get for products,
  2. By increasing liquidity, the Fed makes it harder for other central banks to influence domestic interest rates. This in unison with the increase in export activity stemming from stronger US domestic demand will cause inflationary problems.

These negative externalities are really just the other side of the positive externalities we had above.

For the first negative externality we are focused on countries that export to the US. A weaker US dollar, all other things equal will reduce the price these exporters can charge in order to sell the same quantity of product (in foreign dollars).

The second externality deals with the fact that rising Fed injections to the global credit market will make it more difficult for central banks to control the interest rate (just think of the mortgage wars we had in New Zealand over 2004-05) – as a higher yield gap attracts more foreign funds. Furthermore, all other things equal, an increase in export activity will increase demand for scarce domestic resources – driving inflationary pressures. This is an important point for many countries, given the prevalence of tight labour markets around the globe.

If these negative externalities are dominant, then even if the Fed was acting solely in the interest of the US, they would cut rates past the global optimal level. If the Fed is cutting rates further in order to help the rest of the world they may be doing the wrong thing.

My impression would be that the dominant effect will depend on what is the biggest concern for the world economy at the moment – growth (which US rate cuts will have a positive impact on) or inflation (which US rate cuts are likely to have a negative impact on).  The difference between Fed and ECB action (which is illustrated here) probably comes down to different beliefs regarding what is the main threat to the global economic situation at the moment.

What do you think?  Should we try to prevent a recession or suppress inflation?

2 Responses to "Externalities and Fed monetary policy"

I think there is a coordination game problem for credibility. When the Fed is targeting growth and the ECB inflation, it undermines how credible we believe either will prove to be in carrying through on their prescribed course of action.

To answer your question, I think the Fed is right for now. It is more likely that the ECB will cave and cut rates than the Fed switches to inflation fighting mode. If growth roars back in the States in 2009 (as many are forecasting) then maybe you could say the ECB was right. We’ll see.

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