The Great Global Unwinding

If there is a common factor in the recent global market turbulence it is the inevitable unwinding of unconventional US monetary policy.  Evidence for this connection appeared last May and June when the Fed started talking about tapering, and it is back now as the Fed actually starts engaging in tapering—a process wrought with uncertainty. People can only guess how it will play out, and this uncertainty has always been one of the dangers of these unconventional policies.

Why does the Fed’s unwinding become global? Largely because central bank policy decisions tend to be correlated in today’s highly integrated global financial markets.  We have seen this many times before.  Central banks tend to follow each other, and frequently feel they are forced to.  We saw this as the unconventional monetary policies—what I call a Great Deviation from good policies—were implemented. The very low interest rates and quantitative easing of the Fed forced, or at least encouraged, lower policy rates at other central banks.  Such responses often cause policy to deviate from what would otherwise be appropriate based on domestic considerations.  In part that response reflected concerns about sharp exchange rate appreciations, but the causes are deeper than that as I explain here with comments from Ken Rogoff and Arminio Fraga (pp 27-31).  Empirical research reveals that policy deviations occurred in many countries at roughly the same time as the Fed deviated, creating what Boris Hofmann and Bilyana Bogdanova have dubbed the Global Great Deviation.

Now as the US unwinds from these policies it is causing other countries to shift policy back again–to unwind themselves–in whiplash fashion. What we are seeing here is a Great Global Unwinding of policy following the Great Global Deviation of policy. If there is any contagion going on, it is contagion of policy.  Of course, not all the deviations from good policy are due to policy spillovers from abroad. The terrible policy choices in Argentina and Venezuela in recent years are home-grown

The official Fed view is different. Ben Bernanke argued in a speech last year that what might be seen as central banks’ following each other was actually an appropriate joint monetary easing, which is exactly what was needed then. Moreover, Fed officials frequently point out that it cannot take account of the rest of the world when the mandate from Congress is to focus on the US economy. Yet, recent events show that the rest of the world can feed back on the US economy.

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