New York Federal Reserve Bank President William Dudley warned Thursday of “further bumps in the road” for emerging market nations as the Fed continues scaling back its monthly large-scale asset purchases, and he said the Fed should take into account the impact of its domestic policies on other countries.
Dudley said “vulnerabilities” have arisen in “several important” developing countries, an apparent reference to nations like Brazil and China.
However, Dudley said he is basically “optimistic” about the global economic and financial outlook, now that markets “understand” unwinding “quantitative easing” does not mean the Fed is about to tighten monetary policy by raising interest rates.
And Dudley strongly indicated he believes the kind of international monetary policy “coordination” which some have advocated is not desirable or feasible in prepared remarks to a closed meeting at the New York Fed.
Dudley, vice chairman of the Fed’s policymaking Federal Open Market Committee, acknowledged the FOMC’s “tapering” of asset purchases “has created significant challenges for many emerging market economies.”
Last Wednesday the FOMC announced a third reduction in its purchases of longer term Treasury and agency mortgage backed securities, cutting it by $10 billion to $55 billion per month.
The FOMC simultaneously said it expected to keep the federal funds rate near zero “for a considerable time after the asset program ends, especially if projected inflation continues to run below the Committee’s 2% longer-run goal.” Afterward, Fed Chair Janet Yellen defined “considerable time” as “on the order of around six months,” but said it would depend on economic conditions.
Dudley said the Fed’s policy shift was “inevitable at some point” and is little different from past policy shifts using more conventional methods.
Looking ahead, he said “it seems likely that markets will remain focused on vulnerabilities they might have ignored a year ago” and will put a “greater premium on strong fundamentals, policy coherence and predictability will likely remain.”
The “trade-offs that come with the changed environment, and adjustment will sometimes be difficult,” he warned.
“Moreover, we will undoubtedly experience further bumps in the road,” Dudley continued. “The renewed volatility we saw in January is proof enough of that.”
Nevertheless, Dudley said “we can remain generally optimistic on the outlook so long as market participants continue to appropriately discriminate across countries, rather than treating EMEs as a homogenous group.”
What’s more, he said “many EMEs generally appear better equipped today to handle the Fed’s prospective exit from its exceptional policy accommodation than they were in past tightening cycles” thanks to reforms that have been made, such as greater exchange rate flexibility, reduced debt service burdens, larger foreign exchange reserves and sounder monetary and fiscal policies.
But “progress has not been uniform across EMEs and more work remains to strengthen institutional structures further in some countries,” Dudley went on. “In particular, vulnerabilities have built up recently in several important EMEs.”
Dudley did not elaborate on which countries he had in mind, but did observe that “market participants also had to evaluate the possibility that growth in China and other EMEs might be slowing even as growth in the U.S. and other advanced economies was picking up.”
India’s central bank Governor Raghuram Rajan, among others, has called for greater coordination among the world’s central banks, but Dudley looked askance at that, asserting that “our monetary policy mandate is domestic.”
Dudley did say “our actions often have global implications that feed back into the U.S. economy, and we need to always keep this in mind.”
“We also need to be careful not to underestimate the consequences of our actions…,” he said. Individual impacts may look small, but “when all of the indirect channels of feedback are aggregated properly … the effects may be considerably larger.”
Dudley also said that, given the lack of experience with “unconventional” monetary policy, the Fed “should be humble” about its impact on term risk premia globally.
However, he said “it is far from clear that explicitly coordinated policy would produce better outcomes for the global economy generally, or the EMEs specifically.”
“Central banks have challenges enough in tailoring policies to their domestic circumstances,” he continued. “I believe that it would be taking on too much to attempt to collectively fashion policy in reference to global conditions….Monetary policy meant to suit everybody is likely in the end to suit nobody….”
“While explicit coordination looks neither feasible nor desirable,” Dudley said the Fed and other central banks can and should improve their communication.
He said “it is clear in retrospect that our attempts last spring to provide guidance about the potential timing and pace of tapering confused market participants.”
Dudley contended that the Fed has “done better” with its communication lately, since “markets now seem to understand that policy rates will likely remain exceptionally low for a considerable period of time even after tapering is completed.”
One thing that is needed, according to Dudley, is “a better international mechanism for facilitating adjustment when the direction of capital flows changes abruptly.”
“The current regime strikes me as inefficient and often ineffective,” he explained. “Holding large cushions of foreign exchange reserves is expensive, drawing down those reserves is often unattractive because of the potential adverse signal that this sends, and EMEs are loath to turn to the International Monetary Fund for resources to cushion the adjustment process.”