Steven Kamin on the Global Influence of Fed Policy and the U.S. Dollar

Although the effects of Fed policy can be felt throughout the world, its impacts may not be as pronounced in most emerging markets.

Steven Kamin is a senior fellow at the American Enterprise Institute and previously was the director of the Division of International Finance at the Federal Reserve Board. Steve joins David on Macro Musings to talk about the US dollar and its implications for policy and the economy. Specifically, David and Steven discuss the effects of Fed policy on emerging markets, the factors that are driving a higher global equilibrium real interest rate, how to reconcile the domestic and international impacts of Fed policy, and more.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Steve, welcome to the show.

Steven Kamin: Thanks, David. It's great to be here. I love talking economics, and I look forward to doing so on your podcast.

Beckworth: Well it's great to have you on, Steve, you are a former director of Division of International Finance at the Federal Reserve Board, as I mentioned. So it's great to have a baron on the show to talk about what it was like there, how that was run. Also, you are a friend with John Roberts, a past guest of the show. I know you guys still collaborate working on projects, and we were at a conference together a month or two ago at Kenyon College?

Kamin: Kenyon College in Ohio.

Beckworth: Yes, so I got to interact with you there. And that conversation has led to this podcast recording. So you've had an amazing career, 32 years at the Board of Governors. Again, you were a leader at the Fed. So walk us through your career journey. How did it unfold and what was it like working there?

Kamin: Sure. [I would] be glad to do that. So I want to start a little bit earlier than you might have guessed, when I was six years old, which is when my father, who worked for a banana company, moved us to Honduras. And I spent about five years in my youth in Honduras, followed by a year and a half in Ecuador, both major banana producing countries. And I bring this up because it turns out that lots and lots of folks who are in the international business, not just economics, but also business and diplomacy, have done stints as expats in their youth. And what that gives you is kind of like a deeper interest in international issues. And that's kind of stuck with me, so that in my last year at college, I did an internship at the San Francisco Fed involving international issues. That turned into my spending two years as a research assistant there.

Kamin: And then when I graduated from MIT with a PhD and went on the market, I knew that I wanted to do policy work in international economics. And so it was very natural that I would gravitate toward the International Finance Division of the Fed. So getting now to that, I started in '87, which was toward the tail end of the Latin American debt crisis and started with a portfolio of Colombia, Ecuador, and Peru where I was supposed to follow economic developments and look at their implications for the States; graduated to Argentina, which I had the pleasure of monitoring during their hyperinflation, and this is going to become a theme in my career. I eventually moved toward doing Mexico, the pinnacle at the time of Latin America monitoring and moved there a month or so before the tequila crisis started.

Beckworth: Great timing.

Kamin: Very, very exciting times. Not only because that was a profound financial crisis, but also because the Fed was deeply involved along with the US Treasury and working on the rescue plan for Mexico. A few years after that, when I was promoted to chief of the emerging market economy section, that was in the middle of the Asian financial crisis. And skipping ahead a few steps on the bureaucratic ladder, when I became the director of the International Finance Division in 2011, that was in the middle of the Euro area crisis. And I had the opportunity to testify several times before Congress on the Fed swap lines and what they were doing to keep the functioning of the global financial system going. So I should say that being an economist in the international division was a great job. They're super bright, motivated, and collegial folks working there.

Kamin: There's a great mix of research and policy work, very exciting issues, especially if you like financial crises and lots of opportunities to engage with folks in other central banks around the world. And then being director of the division was even more exciting. I had a great opportunity to help guide the Fed's international outlook forecast, working with folks throughout my division to answer policymakers’ questions, helping to represent the Fed at international meetings, traveling all over the world with Bernanke, Yellen, and then Powell, working on operational issues such as the swap lines, and most recently, the Fed's new FIMA repo facility, and finally even doing a little research on the side.

Beckworth: That is exciting. And you got to work on the swap lines and the FIMA repo facility. I was just talking about that with some friends and the implications of that for the global dollar funding system. We'll come back to that in a bit, but man, you've also had quite the journey. You were at the tequila crisis, the Asian financial crisis, the Euro crisis. You have nice timing, Steve. You just are at the right place at the right time and able to engage in these exciting moments.

Kamin: Yeah, I don't know if I Granger-caused these crises or not, but what all I know is that if I come to monitor your economy, that doesn't bode well.

Beckworth: Steve, what about your work at the BIS? I know you went there, you took some time off, worked at the BIS. You've also worked with the CEA, right?

Kamin: Correct.

Beckworth: So tell us about those experiences.

Kamin: Well, let me start with the CEA first because that was earlier. So the way the CEA is organized is there's three members. They're like the policymakers and they're the ones most likely to go into the president's office and brief him on economic issues. And then they have a core of about 10 or so senior economists that work on different issues in their area of expertise. And then there's some junior economists below them. So, from summer of '92 to summer of '93, I was a [inaudible] to the CEA with the international financial portfolio. And a big part of the job is working to write the Economic Report of the President. So I wrote a chapter on international financial developments over that period. And then working on diverse other issues such as CFIUS, that's the committee to analyze foreign investment into United States and think about restrictions, and a broad array of other things. I will say that international finance is not really at the core of White House or CEA activities. So it's a little bit more of a monitoring and briefing issue than a lot of direct action oriented stuff.

Kamin: And certainly, what was interesting was I was in the transition from the first Bush to Clinton, and in that second half of my tenure in the first half of 1993, almost everybody at CEA except myself was working on the Clinton healthcare proposal. But that was a little bit too much of a stretch for me. So I was like the one person not working on healthcare. So that was CEA. BIS, which I was at from more or less the summer of '97 was working in their emerging market section, just analyzing diverse issues. That's actually where I first started my research into the determinants of emerging market credit spreads, which is something that I'm actually continuing to work on and [I’m] actually about to start a project on that with the World Bank, and where I helped to work on their annual report. And the interesting thing about that was I worked for a colleague who's become a close friend, Philip Turner, who in the annual report that was written in the first half of 1997, was one of the first people to actually foretell the Asian financial crisis.

Beckworth: Oh, really?

Kamin: Yeah. At the time I thought he was a bit of a crank, but he turned out to be amazingly prescient.

Beckworth: Oh, that sounds like an amazing experience at the BIS, CEA, of course, and the Fed for 32 years. Let's turn to some of your research, some of the work you've done and a very topical issue. And let's begin with the global impact of the US dollar. So you have a paper titled, *Will the Strong Dollar Trigger a Global Recession?* And we've had this strong dollar in the US, it really, really grew during the pandemic, it's come down a little bit. But if you look back on it historically, the dollar really took off [in] 2014, 2015, and it's been at this high plateau for some time. And there's always complaining about the strong dollar hurting emerging markets, hurting the rest of the world, being a weight, being a noose around the neck of the global economy. So walk us through that. Why does a strong dollar matter and what were your thoughts on that?

The Effects of Global Dollar Dominance

Kamin: Sure. Well, let me start with, because I think it’s useful to put this in perspective, to talk about what’s been moving the dollar up and down over the last decade. And basically when I think about the movements in the dollar, I focus on two key issues like most international economists do. One of them are relative rates of return differentials between the states and other economies. And then the second factor is the dollar’s rule as a safe haven currency. When things are going wrong in the global economy, people naturally want to seek greater dollar assets because we are the world’s safe haven. So what you saw in 2014, 2015 was that as the US economy started to recover, as unemployment came down and as we were doing a better job in that and a better job of getting inflation up toward our target than in Europe and Japan, anticipations of rising interest rates in the states pushed up the dollar a great deal. And the dollar has, as you mentioned, has stayed in that range ever since.

Kamin: Then, at the beginning of the pandemic, there was a panic in financial markets in early 2020, and that panic led to a huge rise in the dollar, basically reflecting those flight to safety flows. In the panic, everybody wanted dollars. Now, as the pandemic panic and financial markets eased in part due to the actions of the Fed and other central banks, the dollar started to come down again as risk on sentiment returned. And then finally, as inflation surged around the world, and again, the US economy looked stronger than other economies, again, there were anticipations that at least in advanced economies, our rises in interest rates would exceed theirs and that pushed the dollar up.

Kamin: Now, one thing worth noting is that actually the Fed, even though it was among the first advanced economies to push their interest rates up in response to this inflation, that was not true in emerging market economies. They actually pushed up their interest rates considerably earlier and faster than in the United States. And yet the dollar has actually risen against them too, although not as much as against the currencies of the advanced economies. And that increase in the dollar probably in part reflects these flight to safety flows I mentioned earlier, as especially in response to the Russian invasion at Ukraine and the reverberations of that throughout the world. So that’s just a quick sketch of what’s moved the dollar up and down.

Kamin: And now let’s talk about the reasons why a rise in the dollar might be considered injurious to the global economy. And there’s a couple of factors that people focus on. The first is the most obvious, which is that for emerging market economies with a lot of dollar debt, a stronger dollar means that basically it’s more costly for them to repay those dollar debts. And so whenever there’s a rise in the dollar, that tends to dampen prospects for a lot of economies. A second factor that economists point to, and I will apologize if this gets a little bit too wonky, is the issue that the IMF under Gita Gopinath has been pushing called the Dollar Dominance Hypothesis. And so that starts with the fact that everybody agrees with, which is that a large fraction of global trade is invoiced in dollars.

Kamin: Now, what that means is then is that when everybody’s currency falls against the dollar, because everybody’s trade is already invoiced in dollars, even trade between two non-US countries are affected by this. And I’ll give an example to make this a little bit clearer because it took me a while to wrap my brain around it. Imagine a situation where Chile exports wine to Indonesia and it prices that wine in dollars as is often the case. Now, the dollar strengthens against both the Chilean peso and the Indonesian rupiah. And in this scenario, it appreciates the same amount against both of these currencies. What that means is that the bilateral exchange rate between Chile and Indonesia should be unchanged, correct?

Beckworth: Correct.

Kamin: And yet, if the Chilean exporter keeps his price fixed in dollars as they tend to do, that means that Indonesians actually have to pay more in rupiah for that Chilean wine. So that makes it more costly for Indonesia. They suffer when the dollar rises and that reduces the sales for Chile. So in that way, dollar dominance is another factor that basically can lead to a situation where a stronger dollar puts something of a damper on the global economy. And then finally, and this is something that didn’t receive that much attention from academics earlier, but I think is now a little bit more in play, is that in our current global inflationary situation, when the dollar rises against other currencies, that basically means it’s more expensive for the other countries to import goods, and that can be inflationary for them, and that means that they need to do even more monetary tightening than they might have otherwise. So that’s a final factor. So those are all the reasons why a stronger dollar can be somewhat contractionary and, in principle, inflationary for the global economy.

Kamin: Now all that said, I want to point out that in the paper that you described, I noted that these problems were actually not quite as injurious as you might think. And the reason for that is that if the dollar rises against all currencies, that means that that each country’s currency does not necessarily fall against other non-US currencies. And what that means is that their average exchange rate weighted by trade is not going to depreciate as much as their bilateral exchange rate against the dollar. And my paper shows that that’s abundantly the case, that their bilateral currency against the dollar has fallen much more than their multilateral trade weighted currency.

Beckworth: Well, that makes a lot of sense. Let me ask you a question that I’ve thought about that is less clear to me, and it relates to the strong dollar, and I’m wanting to get your take on this because you’ve thought long and hard about it. But we’ve had a strong dollar, it’s come down a bit, but during the same time we’ve also had a lot of inflation. And oftentimes you would think a strong dollar might mean lower inflation, but we have had the opposite thing happening. How do you reconcile those two facts?

Kamin: Well, the way I reconcile them is it's a question of which direction the causality is running in.

Beckworth: Okay.

Kamin: You are right that if you started off in equilibrium and all of a sudden the dollar rose, then that would basically reduce US import prices and exert a disinflationary effect on the US economy, but what's happened is the opposite. The rise in inflation that the US has experienced, has led the Fed to tighten monetary policy, and that's helped push the dollar up.

Beckworth: Okay. So get the causality straight and it all makes sense. So let's talk about what you just mentioned, the Fed tightening rates. So oftentimes we think of the dollar moving in response to the Fed adjusting rates relative to what other countries are doing with their interest rates. And you've had several papers that talk about these issues recently. You had one paper titled, *How Do Rising US Interest Rates Affect Emerging and Developing Economies?* And another paper you have is titled, *Are Higher US Interest Rates Always Bad News for Emerging Markets?* And the first question before we get into the depth of these papers is, is the Fed usually the one driving the change in the dollar? I mean, I know we just talked about [how] inflation prompted the Fed, but at least from a proximate perspective, is it the Fed moving rates around and then causing these relative rates of returns to adjust, the biggest contributor to the change in the dollar?

Is the Fed Driving the Change in the Dollar?

Kamin: I think so. I have to admit that I haven't done the exercise myself, nor have I seen compelling evidence, although there should have been, I guess this would be a good topic to work on. But my informal sense is that if you look at the history of the last couple of decades of the Fed, Fed policy has been an important influence on the trajectory of the dollar. And that's certainly been true in the couple of cases that we've just talked about, the rise in the dollar in 2014, 2015, and the more recent rise in the dollar last couple of years. But thinking about it a little bit more, there have been some pronounced episodes where that's been a little bit less the case. And so the one I am thinking of is the substantial rise in the dollar in late 1990s and the early 2000s, and if memory serves, the dollar peaked around 2002 and then started coming down. That rise in the dollar was not as associated with a particularly profound rise in interest rates, although the Fed was tightening a bit toward the end of the 1990s. And in terms of thinking about that, some of my colleagues at the Fed have worked on theories that revolve around the technological revolution and increase in productivity growth in the United States around that time, that led to a surge in investment spending.

Beckworth: Okay.

Kamin: And so in that sense, [it] raised the prospective rate of return on investments in the US, not so much via Fed action to hike interest rates, but through more general factors associated with basically the dynamism of the US economy. And then if you look at the decline in the dollar from 2002 through 2007 or 2008 or so, that too, not associated with a particular fall in US interest rates. In fact, the Fed was raising rates between 2003 and 2005. So as I say, in the last couple of decades, I think Fed policy has been very important, but it's not the only important driver of the dollar.

Beckworth: That's interesting. There's this literature on the global financial cycle by Helene Rey, and I believe her story is that there is this common factor when there's a shock to the global financial system and it originates in the Eccles Building.

Kamin: Yes.

Beckworth: So it's kind of tied into these linkages we're talking about, right?

Kamin: Exactly. But that said, I'm not a huge fan of that theory.

Beckworth: Okay.

Kamin: And we will be getting to this, but a lot of my research does focus on the so-called spillovers of Fed policy to the rest of the economy. And so it is undoubtedly the case that Fed policy exerts important spillovers to the rest of the global economy and financial system. That is true. But just because when the Fed moves, that has an impact abroad, that doesn't mean it is the main or only source of, basically, developments in the global financial system. So if you think about the financial euphoria and risk taking that preceded the global financial crisis in 2007, 2008, that was like a universal phenomenon that I would say was associated both with financial and technological developments, as well as perhaps this continuing decline in the equilibrium real interest rate, more than the actions of the Fed itself.

Kamin: And then going to the decade leading up to the pandemic, that period of basically low equilibrium real interest rates, below target inflation requiring monetary ease by the Federal Reserve, that was shared throughout the advanced economies. And Europe and Japan did much more monetary accommodation than the Fed. So again, the Fed exerts impact, but that doesn't mean that if you decompose movements in the global financial situation that the Fed ends up being the key driver. Now, we’ve known from a more academic perspective… a former colleague of mine at the Fed, John Rogers, has done research using vector auto aggressions to actually do this decomposition and finds that monetary shocks in the United States explain only a small fraction of the overall variation in global financial conditions.

Beckworth: Okay. Well, let's talk about the specific effect that Fed policy or interest rate differentials can have on emerging markets, because those last two papers I've mentioned deal with that. And one of the interesting questions is, why haven't we seen more pain, more suffering, more injury from the Fed's current tightening cycle? So walk us through that.

The Effects of Fed Policy on Emerging Markets

Kamin: Sure. Well, let me start with the motivation for these papers, and then work to the papers, and then a few hours from now we'll wrap up and talk about the implications-

Beckworth: Fantastic.

Kamin: For emerging markets. So in terms of the motivations, at least for me, this started when I was the director of the International Finance Division, very alert to comments around the world about Fed monetary policy and alert to the discussion at international meetings, where during the taper tantrum in particular, there was a lot of buzz about how US monetary policy was jerking around the rest of the world. And against that background, I noted that yes, there are times like the taper tantrum and the Volcker disinflation when US monetary policy did exert very large, seemingly deleterious impacts on emerging markets. But there were other times when Fed tightening actually seemed to have relatively benign impacts, and that included the tightening cycle under Greenspan and Bernanke from 2003 to 2005 when emerging markets experienced no distress as a result of Fed tightening. So what explained those differences? That's what my colleagues and I wanted to look into.

Kamin: So what we did was, we hypothesized that monetary shocks don't come out of nowhere. When the Fed acts, it tends to be in response to different motivations. And we hypothesize that when the Fed hikes rates in anticipation of stronger economic growth, what we call a real shock, that might actually be relatively benign for emerging markets because they would benefit both from the higher imports of a strong growing US economy and the risk-on or risk loving environment that US economic growth promotes. Conversely, when the Fed is tightening rates either because it anticipates a lot of inflation down the road or because it becomes more hawkish, it just weights inflation more highly in its reaction function, that could be much more detrimental to emerging markets. And that was a distinction that really hadn't been made in previous analyses of the spillovers of Fed policy to emerging markets, which just kind of counted all monetary policy shocks as policy shocks.

Kamin: So what we did was we looked, and I'm referring now to one of the first paper I wrote with my colleagues at the Fed, Jasper Hoek and Emre Yoldas, we looked at how much US Treasury yields changed from before to after each FOMC meeting. So that was a surprise or shock to those interest rates. And then we divided them into those increases in interest rates, I'll just use the case of increases, that were motivated by real shocks and those that were motivated by monetary shocks. And so in order to categorize an increase as a real shock, we look for cases where interest rates would increase and the stock price would increase, because those are the cases where even though the Fed was signaling it was tightening policy, the fact that the stock price went up meant that the markets were happy with that.

Beckworth: Very clever.

Kamin: Actually, I will attribute that to one of my co-authors, Emre Yoldas.

Beckworth: Okay.

Kamin: This is based on a recent but interesting literature started by Nakamura and Stein and then followed on by others looking at the information content of Fed announcements. So going back to it, a combination of higher interest rates and higher stock prices categorized as a real shock; on the other hand, a combination of higher yields and lower stock prices would be considered more of a garden variety monetary shock reflecting either worries about inflation or maybe a more hawkish stance on the part of the Fed. So we looked at a bunch of FOMC announcements in the past decade and then having categorized these changes from before to after each FOMC meeting in that way, we looked at the impact on emerging financial markets.

Kamin: And what we found is that in the case of real shocks, the impacts on emerging markets was really quite benign. On the other hand, when we looked at increases in US Treasury yields motivated by monetary shocks, then you saw deleterious impacts on emerging markets, their currencies depreciated, their bond yields and local currency rose, their credit spreads widened and their stock prices fell. So this seemed to basically confirm our hypothesis that depending on why the Fed is raising rates, it matters a lot for the implications for emerging markets. Then subsequently, I've been working with World Bank colleagues, Carlos Arteta and Franz Ulrich on, basically, a follow-up project. The methodology's been a little different, looking at decomposing monthly changes in interest rates using a structural VAR. And we've done some additional interesting work looking at the impact of these shocks on the probability of a country experiencing a financial crisis. And what we found in that case is that, again, real shocks tended to not lead to financial crisis as much as monetary shocks. And I should note that that last paper with the World Bank has just been repackaged, and is a chapter in the World Bank's Global Economic Prospects report that just came out yesterday.

Beckworth: Very nice. So what bearing does that have for the emerging markets now?

Kamin: Yeah, thank you for that. So in that World Bank paper, we used our vector structural VAR to decompose movements in US Treasury yields over the last couple of years. And what we find is that, indeed, as you might expect, the increases in yields during 2022 have been mainly motivated by monetary shocks, and in particular by shocks to the Fed reaction function and basically reflecting a hawkish shift in Fed policy. Now, I'm not sure that the Fed actually became more hawkish in 2022 than in the previous year. But the VAR interpreted the fact that inflation rose in 2021 and the Fed did nothing, as indicating the Fed was actually a bit dovish. And then the VAR interpreted the rise interest rates in 2022 when a lot of the inflation had already taken place, as reflecting a change in the Fed's reaction function.

Kamin: But in either event, the point is, is that response of interest rates to higher inflation and maybe hawkishness on the part of the Fed should have been very disruptive for emerging markets. And actually, it has been much less disruptive than a lot of observers would've expected. And I think that's true for a number of reasons. The first of these is that a lot of emerging market economies have actually become much better managed and have stronger fundamentals than they did in the past. Their exchange rates tend to be floating rather than fixed. Their fiscal situation is much better than it was in the bad old days of the 1980s. And as I mentioned, their monetary policy has been more effective. And I mentioned that they raised rates a lot faster than the Fed itself did. There's obviously some exceptions including Turkey and Argentina, but most of the emerging market economies better managed.

Kamin: On top of that, a few other things, commodity prices have risen, which has been helpful for a lot of them. A third factor is that back in the day, meaning the 1980s, emerging markets were a niche product for investors. And so at the first sign of trouble, investors would pull back, but these days, emerging markets are part of a standard portfolio of international investors, and so they don't flee at the first sign of trouble. And they're much better at distinguishing high risk countries like Argentina from lower risk countries like Mexico. And then the final reason I think that the emerging market world has been less impacted by Fed tightening is because that tightening has been generally considered, in both US markets [and] around the world, to be temporary. And as interest rates go back down again, the pressure should decline.

Kamin: Let me make one last point, which is so far I've been talking about like these middle income emerging market economies. But what is true is that a lot of lower income economies in Africa and other… especially that are poorer, more poorly managed, and have much more fragile access to international capital markets, have been impacted more by the rise in rates. And that's also true of the so-called frontier emerging market economies like Kazakhstan or Nigeria that gained access to international capital markets in the last decade during the period of low interest rates, and now have lost that access. So for those economies, the impact of the Fed has been tougher.

Beckworth: That is so fascinating, and I'm glad you bring up the explanations for your identification in your VAR going back to your papers where an increase in the stock price, a real shock, does not lead to a destabilizing outcome for the emerging markets. And to me, that is very consistent with what I would consider standard macro theory. If productivity goes up, but the fundamentals of an economy improve, you would expect the equilibrium real rate to also go up and not be a problem, right, for the economy.

Kamin: Exactly.

Beckworth: In fact, you would want it to go up, otherwise it might overheat.

Kamin: Exactly.

Beckworth: And so this is a very clever, I think, identification, but also intuitive. And let me tie that to a point you made here at the end that some of the emerging markets aren't doing as bad because they believe, or the markets believe, that the Fed's tightening will be a temporary phenomenon, which then in turn implies that these markets… and some people believe that the fundamentals suggest we're going to return to a low rate world going forward. And this all ties together in my view as to what is your theory of interest rates? And I want to run this by you because I get in these exchanges and you know what I'm going to ask, but kind of again, standard macro theory.

Beckworth: We have this desired savings, desired investment, basically the fundamentals, if expected productivity goes up, population growth goes up, time preferences change, that should affect medium to long run equilibrium real rate. In the short run though, there's money view, a liquidity preference theory view, Keynes, that the central bank, the Fed, can adjust them. And somewhere in the middle they blend as you go farther out on that horizon. So I ask this because, going back to your discussion about what effect does the Fed have on the global economy, well, at the end of the day, if you believe in the standard approach, there's going to be fundamentals that drive those rates. The Fed can't set the global interest rate on a sustained basis. It might have temporary effects, but over the medium to long run, the fundamentals will drive the global equilibrium real interest rate. Is that fair?

What’s Driving the Global Equilibrium Real Interest Rate?

Kamin: Well, let me first agree with you that both these factors are operative, the fundamental macro side view where the interest rate equates investment and saving and is driven by underlying factors such as productivity trends, demographics, preferences, et cetera. And at the same time, it's actual monetary conditions in the economy that basically pinpoint the actual interest rate. All that said, I guess I might conceptualize a little bit differently, in particular, in regards to the short run and long run, because I think that even in the short run, these fundamental conditions are very important. So let me repackage what you said slightly, if you don't mind-

Beckworth: Sure.

Kamin: …In terms of we Fed economists' favorite concept, r-star. So as you know, r-star essentially is the real interest rate that would equilibrate the economy and corresponds to your fundamental macro view. It's the one that equates desired saving and investment. And it's the one where when the interest rate is at r-star, gives you price stability and maximum sustainable employment. And the point is that as you point out, that r-star is indeed driven in the long run by these fundamental factors of the US economy. And as they evolve over time, r-star evolves as well. The point I want to make is that those fundamentals that are driving r-star are not constant or only slowly moving, they're actually impacted by shocks, even in the short run.

Kamin: And so therefore, my conceptualization of the process is that while long run r-star might evolve slowly over long period of time, such as when we saw r-star decline from the 1980s through to right before the pandemic, as the fundamental determinants of r-star are basically bounced around by shocks to the economy, that moves a short run r-star up and down. And so when the Fed is basically moving interest rates up and down, on a near term and medium term basis, it's not doing that just because of these liquidity preference issues. It's actually doing it in an attempt to match the movements in the short run r-star. And if it didn't try to do that, then we'd have bigger recessions, more inflation, et cetera. So that's my conceptualization of that part. And then now moving to the money part, the liquidity issues you mentioned, that obviously is what the Fed needs to manipulate in order to get to that policy interest rate that matches that short run r-star.

Beckworth: So that all makes sense and I think it's important to wrestle with that because when we think about the future of interest rates, at least for me, I want to know what's driving them. And I think these fundamentals are going to return us to a low interest rate world. I'm wondering what you think about that. Are we going to return to what, as you would say, a low r-star world or have we had a permanent shock that has elevated r-star to a new level?

Kamin: Right. Well, I guess my inclination is to agree with you that in insofar as the tumultuous economic events in the last few years, the pandemic, the pandemic crisis and recession, the recovery, and now this inflationary surge, all of these appear to be transitory, if I can use that word. If it hasn't been permanently besmirched… transitory responses in the last few years. In principle, I would think that when the dust settles and when we're through with all of the reverberations of the pandemic, we ought to go back to where we were before. But as you know, there are other folks that believe that there are other fundamental factors that may lead to a higher r-star and a more inflationary environment than we were before; a prominent book by Charles Goodhart-

Beckworth: Yes, I was thinking of that too.

Kamin: Exactly. And he pinpoints, I guess, a couple of factors. The main one is the fact that globalization has run its course, not in the sense [that] the economy is de-globalizing, but just that the integration of China into the world economy has now largely been completed. And he also points at demographic factors that also point that direction. So I think that makes sense, and I think that's a good reason why, going forward over the next years or decades, that r-star could indeed increase.

Beckworth: Okay.

Kamin: As demographics lead, more old people, et cetera, but whether or not that takes place, I view those as long-term secular factors. And I see no reason why in between 2019, when we were in a very low r-star world, and 2025, that those sea changes in the determinants of r-star should have changed that much.

Beckworth: Okay. And you can use transitory here, it's a safe place to use transitory. We just defined it as a little bit longer horizon that was initially used.

Kamin: Well, I think that may have been what the Fed had in mind, but-

Beckworth: Yeah. Well, let me go back to the book that you mentioned by Charles Goodhart and he tells a story that aging demographics may actually lead to higher inflation, where that's… the kind of standard story has been flipped. Well, Japan has this aging population, shrinking population, and they've had low inflation. And his story is, I believe, and correct me if I'm wrong, that these people are going to start to spend in their retirement, they're going to work less, they're going to spend more, and that's going to create inflationary pressures. Also, it's going to just increase r-star. But you could tell the other story. The other story is [that] as the world ages more and more, people realize they’ve got to save more for the future. Number two, they're also risk averse. An older person's going to be much more cautious in how they spend, and their portfolio of savings may go from riskier to safer assets. So you have these two countervailing forces. On one hand, they're going to start spending what they've accumulated. On the other hand, they might be more cautious, maybe saving more if they're going to think they're going to live longer. And so you come out on the side that it may, on balance, lead to more spending, higher inflation, and higher r-star.

Kamin: Well, let me put this way, it's a view with which I have only very weak conviction.

Beckworth: Okay.

Kamin: It seems to me to make some sense that as we eventually get to a world with very few working people and quite a few not working people, it makes sense that in that situation that the pressure of demand against supply would be something to put us in a more resource scarce world in that sense than we have in the past, leaving aside labor saving technological developments that could defray that. But on the other hand, and I think this actually goes to the Japan issue, in a world of very slow population growth and slow labor force growth, that's actually a world where you need a lot less capital accumulation than you did in the past. And that, by depressing investment demand, tends to lower r-star. And I think that that actually has been one of the factors in Japan and even the United States in terms of our low r-star world of the previous decade, just like deficient investment demand. So as I say, I think there are excellent reasons to believe either side of those stories, and that's why my conviction is exceedingly weak on how those will balance out.

Beckworth: Only time will tell as they say. So let's go back to your role as director of the Division of International Finance at the Federal Reserve Board, and go back to this point we were discussing earlier that Fed policy can have a global effect. It depends on many circumstances and factors as you mentioned, but oftentimes when it does and is at least is perceived to be creating issues and challenges, there's always a call for the Fed to take the world economy into mind when it's setting policy. But in fact, the Fed has a domestic mandate. It has to set policy for what's happening domestically. I remember for example, maybe it was 2015, Governor Lael Brainard had a speech where she highlighted this tension. We set interest rates for our US economy, a domestic mandate. But what happens is it can affect the global economy and maybe to the extent that comes back and affects us and directly, we account for it. But as someone who headed that division, this is an issue you probably wrestled with a lot, right? What can be done about it? Anything? I mean, can we coordinate central bank policy? What's the path forward when there is in fact tension there?

Reconciling the Domestic and International Effects of Fed Policy

Kamin: Yeah. Well thank you for that. First, I didn't really wrestle with it. It was pretty clear that the answer is that the Fed is mandated by law to basically pursue its domestic stabilization of objectives of stable prices, maximum sustainable employment and financial stability. And it's not just the Fed that's mandated to do that. All central banks are mandated to follow their domestic objectives and so they're not going to do any differently. But a couple of things. First of all, this policy, which sounds... Well, let me be specific about what the Fed can and cannot do here.

Beckworth: Yeah.

Kamin: What it can't do is to choose policies that might be helpful for the rest of the global economy, but what, in some sense, not be helpful for the US economy. By law it has to focus on policies that are good for the US economy, just like [how] all of the central banks are doing that for their countries. But that is not necessarily injurious to the rest of the global economy, and let me be more specific about that. Let's say that the US economy was a bit stronger than the rest of the global economy and we were faced with an inflationary surge. Now there might be observers out there who would call for the Fed not to raise interest rates, because by doing that it would hurt emerging markets or other economies.

Kamin: But that would actually not be a good idea, because allowing inflation to rise or get out of control would only mean that later on the Fed would have to raise interest rates by more and faster, and that would be even more injurious to the global economy than acting right away. And that is a point that other policymakers in other countries, particularly central bankers, understand very well. So even during times when politicians in other countries are bashing Fed policy, their central bankers tend not to, and they understand the issues involved. So I was at a G-20 meeting, in 2015, as I recall. This was like as anticipations were growing of the Fed's first rate hike after a long hiatus, a lot of buzz about what it might do to other countries. But actually, policymakers around the table were actually calling for the Fed to go ahead-

Beckworth: Interesting.

Kamin: …End the suspense. And as one of them put it, to rip off the band-aid.

Beckworth: That is very fascinating.

Kamin: So they get it. The other point I want to make here is that just because the Fed is mandated by law to pursue domestic objectives doesn't mean it ignores the rest of the global economy. And economic conditions in the rest of the world affect the US economy. And so when the Fed pursues any type of policy action, the Fed monitors very closely the spillovers to other economies, and it takes into account and monitors what the IMF considers the so-called spill backs of those policy impacts back onto the United States. And that was the job of the International Finance Division to do the monitoring of both the spillovers and the spill backs. And then the final point I want to make is in policy coordination. So typically in these situations, observers call for the Fed not only to pay more attention to the needs of other economies, but to also engage in policy coordination. The idea being that with all these spillovers, these externalities, a coordinated policy environment makes more sense.

Kamin: First of all, I'm a little skeptical that these externalities really call for that type of policy coordination. And as I mentioned before, not only is the Fed unable to participate in policy coordination per se, but so are other economies. But what is true is that the Fed officials are in constant engagement with officials from other central banks, and there's continuous discussion, especially in Basel, about the common problems that central banks face [and] how to deal with them. So all of the central banks are very aware of what each other is doing. And although there isn't policy coordination per se, I would say that there's policy cooperation and exchange of views that accomplishes a lot of the same thing.

Beckworth: Very interesting. And just going back to this point you made earlier about behind the scenes, fellow central bankers are encouraging the Fed to raise rates. What we see on the outside are finance ministers screaming, “currency war!”-

Kamin: Exactly.

Beckworth: “…Infinity for QE, it's going to destroy the rest of the world!” So very fascinating to peel back and look deep down inside and see that, actually, the more sober minded policymakers are saying, thumbs up-

Kamin: Exactly.

Beckworth: …Keep it up. Well, let's continue talking about this international dimension and let’s come back to the observation you made earlier about your work on currency swap lines and the FIMA repo facility because that is one way that the Fed would assist countries outside the US, if something happens and maybe Fed policy does cause a disturbance somewhere, they can always use those facilities if needed to help smooth things over. I want to know, though, the history of those as you saw them. So 2008, great financial crisis, they were used 2009, I believe 2011 during the Euro crisis, they were tapped.

Kamin: Yes.

Beckworth: And then obviously most recently, 2020 they were used. And then the list of counterparties or other central banks that had access to them grew, at least the temporary list grew. So help me understand how that list was made. Why did certain countries make the cut and other countries did not? What was the criteria?

Determining the International Criteria for the Fed’s Facility Use

Kamin: Well-

Beckworth: Or is that classified information?

Kamin: I don't know that it's classified or not, but it hasn't been discussed very widely. So I might be a teeny bit less forthcoming.

Beckworth: Okay.

Kamin: But well, let me talk a bit and obfuscate. So there have actually been swap line arrangements for decades and those that were done with other advanced economies, what at the time were called like G10 economies.

Beckworth: Yes.

Kamin: Now a lot of that was done actually for the purpose of exchange rate intervention, which is now policy non grata. And there were also swap line arrangements with Canada and Mexico kind of associated with the North American Financial Agreement, connected with the NAFTA. But then with the financial dislocations in 2007 and 2008, new swap lines were developed in order to basically be able to channel dollars to financial institutions in other countries that would need those in situations where, basically, dollar lending was very hard to get ahold of. And basically the criteria was to provide these swap lines to countries that had major financial centers, so they were important, that had well managed and records of well managed monetary and financial policy, and that were basically considered very strong credit risks.

Kamin: And so that led to an initial short list of central banks such as the Bank of England, the ECB, Swiss National Bank, Bank of Japan, and then I think a little later, Bank of Canada. And then it was recognized as the global financial crisis deepened after Lehman Brothers, that there were other financial systems that were also being impacted very severely and a wide-ranging need for these. And that's when it was expanded from five central banks to 14, including four emerging market economies, Korea, Singapore, Mexico, and Brazil. And so that prevailed during 2008, 2009, kind of went away. And then when the Euro crisis started... and during that period, swap line drawings went up to over $500 billion. They went up less during the Euro crisis where, it being a more concentrated crisis involving central banks that were already like permanent swap line members, the swap line drawings increased not by as much and just to the permanent members of that community.

Kamin: And then finally, with the pandemic, there was a need again, given that it was a global factor and leading to a global financial panic, to expand it again to more countries that needed it. And then it was a no-brainer. Let's just go with the template that we used before. So the 14 countries that got it back in 2008, again getting it in 2020. And again, those drawings had declined a lot once the panic went away as they were supposed to do. And then the novelty of the 2020 pandemic was that the Fed introduced this new FIMA repo facility, which was basically a way that other central banks, especially those that didn't have access to swap lines, could take their Treasury bond holdings and basically use them as collateral at the New York Fed in order to get cash money. And that was considered a much more advantageous approach than having these countries actually have to sell the Treasuries into the market at that time in order to raise the funds they needed.

Beckworth: And that also opens up more countries to have access to the Fed’s balance sheet, to have access to those dollars. And I know this can be a contentious issue because Congress may not approve of every country that comes to the Fed's door and asks for dollars, and I'm thinking of one country in particular, China, you can imagine if China... Now China would not need dollars because they have a huge stash of foreign exchange reserves and they did not get a currency swap line, I think, for obvious reasons that would look really bad on the Fed, or at least it would be questioned, I would imagine. But the FIMA facility does allow China, though, if it wanted to, to sell Treasuries to the Fed and then get dollar reserves, correct?

Kamin: As far as I know, it did. I will admit that I helped work on that in the waning days of my career at the Fed. I stepped down from being division director, I think at the end of January of 2020, and then just hung on for a few months-

Beckworth: During the crisis.

Kamin: …Including an extra month to work on this. But with the passage of time, the memory gets hazy. But I'm moderately sure that we didn't have any particular restrictions on particular countries. Although there might be something in the fine print that would've allowed us, the Fed, on a more discretionary basis, to encourage or discourage. So, I can't be committal on that.

Beckworth: Yeah, and to be clear, again, China would not need this facility currently.

Kamin: Absolutely.

Beckworth: They don't need it with all the reserves they have. But maybe a country like India, which doesn't have a currency swap line, would benefit from the FIMA repo facility. You could deposit Treasuries-

Kamin: Sure. I should note, by the way that reserves include Treasury holdings. So the fact that a country has a lot of reserves doesn't mean it might not need to cash in the Treasury bonds because most or all of those reserves could be in the form of Treasury bonds and it would need to liquidate those in order to actually intervene in FX markets.

Beckworth: Yeah. Okay, with that, our time is up. Our guest today has been Steven Kamin. Steven, thank you so much for coming on the show.

Kamin: Very enjoyable conversation, I love chatting economics and I love your questions. So it was a pleasure to be here.

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.