BIS Review Nos. 56 & 57
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BIS Review No 57 (23 June 2006)
Jean-Claude Trichet: Celebrating the 50th anniversary of the Paris Club
Stanley Fischer: "The Paris Club at Fifty"
Seong-Tae Lee: Monetary policy in an environment of low inflation
Shamshad Akhtar: Development of microfinance
Krzysztof Rybinski: Globalisation and its implications for monetary policy
Usha Thorat: Treating bank customers fairly - regulatory initiatives
Susan Schmidt Bies: A supervisor's perspective on mortgage markets and mortgage lending practices
Randall S Kroszner: Why are
yield curves so flat and long rates so low globally?
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Friday, June 23, 2006
Please findBIS Review No 56
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Toshihiko Fukui: Financial markets and the real economy in a low interest rate environment
Y V Reddy: Global imbalances - an Indian perspective
Vitor Constâncio: Finance and regulation
Philipp Hildebrand: Swiss monetary policy
Rakesh Mohan: Monetary policy and exchange rate frameworks - the Indian experience
Yiu-kwan Choi: The debt market of Hong Kong - what can we offer to investors?
Mark W Olson: What are examiners looking for when they
examine banks for compliance?
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Thursday, June 22, 2006
Globalisation and its implications for monetary policy
Address by Mr Krzysztof Rybiński,
Deputy President of the National Bank of Poland,
at a series ofseminars by the
Centre for European Regional and Local Studies
and the UNESCO Chair, Warsaw
University, Warsaw, 6 April 2006.
* * *
Ladies and Gentlemen,
Globalisation is a term used frequently in the economic debate nowadays, and it would be difficult to
find an area of economic research that is "globalisation-free". However, its meaning is so broad, that
when globalisation is referred to in a discussion, various people understand various things. For this
very reason, a discussion on globalisation and the monetary policy should commence with an attempt
to define the term.
One of the definitions of globalisation is provided by the International Monetary
Fund (IMF)1, where it is construed as "the growing interdependence (integration) of national
economies, in particular as a result of the growing international trade and financial flows". Moreover,
an element of globalisation that is worth mentioning is the fast flow of information and knowledge,
which is the driving force behind globalisation processes. One should keep in mind that globalisation is
not a completely new phenomenon2. In view of the existence of political barriers to international trade,
the flow of capital and goods was equally as possible one hundred years ago as it is today. It goes
without saying, however, that as a result of the rapid development of technology, especially in the ICT
area, which drastically lowered the cost of the said exchange, the international integration of trade,
investment, financial and other services is now more advanced than it has ever been before.
The Economic Policy Committee of the European Union3 points out four factors that have lead to the rapid development of globalisation over the past years:
multilateral trade liberalisation; the average customs duty has been lowered by ca. 30%
successful economic reforms in many developing countries, especially in China and India
the technological advancement, especially in the ICT sector and transportation, which has
significantly lowered the cost of trade. To give you and example, fees for sea, land and air
transportation, telephone calls and satellite calls went down by 21%, 30%, 95% and 88%,
the technological advancement has blurred the borderline between what can and what
cannot become subject to international trade.
Globalisation may create new macroeconomic interdependences to replace the traditional ones that
we know from the books on economics. The majority of economists, politicians and investors may still
not quite keep at pace with the "seismic changes" that take place in the economy4. However, if we
really are witnesses to "seismic changes" in the economy, it may be worthwhile to have a closer look
and think about their meaning.
Globalisation and its impact on the economy may be viewed from different perspectives. Today I
would like us to look at globalisation from the perspective of a central bank, taking into consideration
the objective of the central bank, its ability to contribute to the shape of the economy and the
instruments that a central bank has at its disposal. To start with, let us consider what channels there
are through which globalisation may impact the monetary policy and the central bank.
1 "Economic globalization is a historical process, the result of human innovation and technological progress. It refers to the
increasing integration of economies around the world, particularly through trade and financial flows. The term sometimes
also refers to the movement of people (labor) and knowledge (technology) across international borders." According to:
"Globalization: Threat or Opportunity?" IMF Staff, April 12, 2000 (Corrected January 2002).
2 See e.g. Mussa M. "Factors Driving Global Economic Integration" presented in Jackson Hole, Wyoming at a symposium on
"Global Opportunities and Challenges," August 25, 2000.
3 Economic Policy Committee "Responding to the Challenges of Globalisation", November 2005.
4 Roach S. "The New Macro of Globalization", Morgan Stanley Global Economic Forum, 6 June 2005.
BIS Review 57/2006 1
Firstly, globalisation - through shaping real economic processes abroad, its influence on the global
business cycle and commodity prices on global markets - influences the external environment of the
national economy, which is monitored by the central bank and in which the central bank operates.
Today, a central bank in a small open market economy, which would wish to turn a blind eye on the
developments in the external environment and focus solely on the developments in the national
economy, is doomed to failure.
Secondly, globalisation changes the wage and price setting mechanisms in the national economy,
which have an impact on the domestic inflation. Globalisation (the growing openness of economies) -
through the growing share of countries with low manufacturing costs in the global output - increases
the margin and wage pressures, in consequence lowering the inflation. At the same time, globalisation
drives up commodity prices, and thus contributes to - at least temporarily - increased inflation.
Thirdly, increased international migration of workforce changes the situation on local labour markets.
Where the workforce outflows, the wage pressures increase; in the case of an inflow of workforce, the
wage pressures go down.
Fourthly, globalisation changes the functioning of financial markets and increases the uncertainty as to
the impact of decisions made by the central bank on these markets and on macroeconomic variables.
Fifthly, globalisation has an impact on the central banks perception of the economic environment and
the monetary policy strategy it applies. A fast transfer of the economic know-how (flow of the economic
knowledge and analytical methods) changes the methods of economic analysis by central bank
economists, as well as the way decisions regarding the monetary policy are made.
Sixthly, globalisation increases the risk of speculative bubbles on the assets market.
Let us have a step-by-step look at these channels of influence of globalisation on the monetary policy.
The growing share of international trade in the global output as well as the increasing international
capital flows cause a situation, where the growth rate of a national economy depends increasingly on
the developments of the global economy. To illustrate the impact of globalisation on the economic
prospects, attention should be drawn to the hot topic in the macroeconomic policy, namely the
problem of global imbalances.
To give you some facts, the US current account deficit had been growing gradually over the past years
to exceed USD 800 billion, i.e. 6.5% of the U.S. GDP, last year. This deficit, which represents import of
savings from the rest of the world to the USA, is financed by the Asian central banks, for example the
Peoples Bank of China, and by oil-exporting countries. The available forecasts show that the deficit
will continue to grow. An animated debate is currently underway to determine whether this is a steady
situation that simply reflects the new principles in the global economy5, or whether this trend is bound
to stop and reverse sooner or later, which may entail a significant increase in the US long-term interest
rates, a strong depreciation of the US dollar and a serious slowdown in the global economic growth.
The majority of empirical and theoretical studies indicates a growing probability of the latter scenario,
especially if no due steps are taken in many countries. These steps include the necessity to accelerate
the potential GDP growth in the European Union and Japan through reforms of the labour market and
the product market, increasing savings in the US by curbing the budget deficit, and reforms of the
financial sector in China and subsequent gradual floating of the renminbi exchange rate.
The central bank must consider possible scenarios of developments in the global economy and
possible adjustments of global imbalances, as they significantly impact the perspectives of a national
economy, and so the monetary policy pursued. Moreover, the central bank, as an institution that
manages foreign exchange reserves, must monitor changes on the global financial market, as these
changes and investment decisions made by the central bank influence the return on foreign exchange reserves.
5 This thesis was advanced, among others, in the frequently quoted work: M.Dooley, D.Folkerts-Landau, P.Garber "An Essay
on the Revived Bretton Woods System", NBER Working Paper 9971, September 2003.
2 BIS Review 57/2006
Globalisation changes the wage and price setting mechanisms in a domestic economy. This ensues
from the increased international competition and the growing role of outsourcing and offshoring.
Offshoring consists in transferring of manufacturing, services or orders abroad, where such transfer
may be made within a single company or to another company. Outsourcing consists in renouncing
manufacturing or services in a given company and obtaining such goods or services from another
company that may be located in the same or another country.
In the past, the major part of the chain of manufacturing and services used to be located in a given
country, which meant that, from the monetary policy perspective, the domestic demand was of great
importance, and in particular - the size of output in relation to its potential level i.e. the so-called output
gap. The impact of the global economy, on the other hand, was observed mainly due to changes in
the terms-of-trade i.e. the ratio of export to import prices, which in turn was affected by, among others,
commodity prices and changes in external demand. Nowadays,inter alia as a result of globalisation of
production and services, the role of the domestic output gap in explaining inflation has decreased
significantly, as shown by the BIS research6. As in the case of the model applied by the NBP in
forecasting inflation, the role of the output gap as a factor that determines inflation is much smaller
than it used to be.
In old books on macroeconomics inflation is treated largely as a local development, i.e. dependent in a
great measure on domestic factors (such as the domestic output gap and inflation expectations).
Today, inflation is becoming increasingly less local, and in turn, becomes more and more dependent
on global factors, i.e. the relationship between global demand to global supply. Research that
analysed the course of inflation in 22 OECD countries between 1960 and 2003 has shown that 70% of
inflation volatility may be explained by a common factor7. This global, common factor explains not only
the change in the inflation trend (the increasing inflation between 1960 and 1980 and its subsequent
decrease), but also inflation fluctuation over a business cycle. The research has also shown that,
where domestic inflation deviates from the "global" inflation, it exhibits a "global-inflation-reverting"
tendency. As a consequence, modelling and forecasting of domestic inflation may be improved
significantly by taking into account the "global inflation".
The fast-progressing globalisation is closely related to offshoring and outsourcing, whose scope is also
growing. Unfortunately there is not much hard data that would allow for assessment of the scale of the
phenomenon. Offshoring analysis is available only for selected countries and covers only selected
industries. However, the growing scale of the phenomenon is reflected by data on global trade in
goods and services and on foreign direct investment. Over the past 15 years, the shares of individual
regions in the global trade have changed significantly, whereby the decreasing share of the EU is
accompanied by increasing shares of the developing countries, including the Asian countries. Globally,
foreign trade expressed as percentage of the GDP increased from the average 19% of the GDP
between 1980 and 1989 up to 25% between 2000 and 2004.
Table 1. Shares of individual regions in global trade
% Total 1990 1995 2002
Developed countries 72 67 63
US 12 12 11
UE15 44 39 38
Developing countries 28 33 37
Asia 13 19 20
Source: IMF Direction of Trade Statistics
6 BIS 75th Annual Report, 2005.
7 Ciccarelli, Mojon "Global Inflation", Central Bank of Chile Working Papers No 357, December 2005.
BIS Review 57/2006 3
Global capital flows keep growing even more dynamically, whereby the share of the global FDI in the
global GDP increased from 8% in 1989 to 22.1% in 2003, and foreign assets expressed as percentage
of the GDP increased from 62.6% of the GDP to 186.1% of the GDP, respectively.
As evidenced, the role of trade and financial links between enterprises in various countries has
become more important over recent years. Previously, in response to growing fuel prices or costs of
living, trade unions demanded wage increases, which triggered the so-called second-round effects
and central banks had to increase interest rates to mitigate inflation. Nowadays, trade unions must
take into account the fact that in the case of wage increases, production and services may be
transferred to countries with lower manufacturing costs.
In EU Member States, between 2002 and November 2005, 202 cases of the restructuring of
companies related to offshoring were publicly announced, which resulted in the transfer of nearly one
hundred thousand jobs. Over that period, offshoring stood behind nearly six per cent of all cases of
publicly announced restructurings of companies in the EU. So far, the scale of the phenomenon has
not been large. However, offshoring as a strategy of increasing competitiveness is becoming more and
more common and includes not only the manufacturing of products but also - increasingly - services.
Table 2. Offshoring in EU member states
Countries to which job transfer
Number of jobs liquidated in the
EU between 2002 and 2003
due to transfer of jobs
Number of jobs liquidated in the
EU between January and
November 2005 due to transfer
China 3361 3077
India 9458 5470
Asian countries 3786 3271
Czech Republic 780 3890
Hungary 1110 772
Poland 120 2676
Source: European Restructuring Monitor8, own calculations
Numerous analyses show that the process of offshoring is bound to grow and increasingly affect
services9. For example, between 1980 and 2002 the trade in goods and services grew at 6.9%.
According to forecasts by McKinsey Global Institute, off-shoring of services to countries with low
manufacturing costs in the years 2003 2008 is going to grow at a rate of 30% annually. In 2003, the
global trade in services was ca. USD 1.7 trillion, of which a mere 3% resulted from offshoring to low
cost countries. It is expected that in 2008 the global trade in services will amount to ca. USD 2.4
trillion, of which 10% will represent offshoring of business and ICT processes to low cost countries. To
compare, the travel industry represents 30% of trade in services in the OECD data, whereby
transportation - 20%. Based upon an analysis of eight representative sectors, McKinsey Global
Institute estimated that in 2003, 18.3 million jobs in services could have been transferred to other
locations (this applies mainly to sectors such as IT - 2.8 million, banking - 3.3 million, insurance - 2.3
million, healthcare - 4.6 million and retail sales - 4.3 million). Extrapolating the results for the global
economy, it may be estimated that in 2008 ca. 160 million jobs in services, i.e. 11% of the global
employment in services estimated at 1.46 billion, may theoretically be performed at a distance from
8 European Restructuring Monitor is the European Commission service. It gathers all publicly announced cases of
restructuring of companies in EU Member States, Bulgaria and Romania if these fulfil on of the following conditions:
reduction of employment by at least 100 people within a year, they apply to companies that employ at least 250 people and
the redundancy applies to at least 10 per cent of employment, or if as a result of restructuring at least 100 jobs are to be created.
9 McKinsey Global Institute "The Emerging Global Labour Market", June 2005.
4 BIS Review 57/2006
From the monetary policy perspective, it is important to properly understand the impact of offshoring
on the functioning of local labour markets, which - as a result of ever greater opening of the economies
- have merged into one global labour market. Before the fall of socialism in European countries, the
then global market amounted to ca. one billion people. Nowadays, i.e. after China and India have
joined the global economy, the market comprises ca. four billion people. This brings about a situation
where jobs are being transferred to new, more attractive locations and people increasingly move in
search for better-paid jobs. The largest migration known as "the great migration" is taking place in
China10. According to estimates, over the next 10 years ca. 200 million Chinese will migrate from
villages to cities and find employment in industry - to a large extent in export-oriented industry sectors
- and in services. This means that over the next 10 years, every month one to two million Chinese on
average will give up their low-paid, low-productivity jobs in agriculture and take up better-paid and
more productive work in other sectors. The monetary policy must take into account the impact that this
process is going to have on the Chinese economy and on economies of other countries.
As opposed to trade and capital, the flow of people within EU Member States was stable. The annual
net migration to EU-15 remained at a level of less than 5 people per 1000 inhabitants over the past 40
years. Approximately 9% of EU population was born in other countries, whilst in the USA this figure
was 12% and ca. 20% in Canada and Australia. However, following the EU enlargement, where 10
new members joined the structures, our part of the world has also seen an increase in migration,
which is shown in Table 3 below. In some cases, a significant part of the domestic work force took up
employment in other countries. The estimates show that, for example, ca. 5% of Lithuanians took up
employment in countries that opened their labour markets for the new EU Member States following 1
A conclusion may be drawn that opening of the low cost economies, especially of the Chinese
economy, and the increasing international competition on the market of goods and services related
thereto, changes the methods of setting prices by enterprises and determining wages on the labour
market. Enterprises are increasingly becoming price-takers, and thus even in a situation of rising costs
of manufacturing, they are unable to lift prices and shift the growing costs onto the customer. Similar is
true for wages, whose level is determined on the increasingly global labour market. Research on the
manufacturing sector in EU Members States (for the years 1988 - 2000) has shown that the increase
in the openness of that sector (growing import) caused a fall of prices by 2.3%, a growth in productivity
by 11% and a drop in margins by 1.6%. Altogether, it may explain the inflation fall by 0.14% in annual
terms over that period11. When looking at the price processes from the microeconomic perspective,
vital structural changes can be observed, which bring about lower inflation.
Table 3. Number of work permits in the UK, Ireland and Sweden issued to citizens of new
Member States following the EU accession
UK * Ireland** Sweden*** Total
In % of
Lithuania 44.72 26.37 0.37 71.46 4.4
Latvia 23.03 12.94 0.16 36.14 3.2
Estonia 4.68 3.39 0.36 8.43 1.3
Poland 204.90 70.14 2.16 277.20 1.6
Republic 20.01 6.39 0.07 26.47 0.5
Hungary 10.35 3.83 0.20 14.37 0.3
Slovakia 36.36 10.93 0.09 47.38 1.8
10 HSBC "The Great Migration. How Chinas 200 million new workers will change the economy forever", HSBC Global
Research, October 2005.
11 Chen N., Imbs J., Scott A. "Competition, Globalization and the Decline of Inflation", CEPR Discussion Paper No. 4695,
BIS Review 57/2006 5
*Source: Accession Monitoring Reports,http://www.ind.homeoffice.gov.uk.
The data include the period between May 2004 and
December 2005. NBP calculations.
**Source: Skills needs in the Irish economy: The role of migration, A submission by the Expert Group on Future Skills Needs
and Forfás to the Minister for Enterprise, Trade & Employment,http://www.skillsireland.ie. The data include the period between
May 2004 and August 2005.
***Source: Migracje specjalistów wysokiej klasy w kontekcie członkostwa Polski w Unii Europejskiej. Centre for Migration
Research, Warsaw University. The data include the period between May 2004 and December 2004.
Workforce people of 15 and more years of age in Q1, 2004.
Analysts also point out that the dynamically growing Chinese economy, which uses more and more
commodities, contributes to a significant increase in their prices, and may potentially drive up inflation.
However, considering the increased competitive pressure, the possibility of shifting higher cost of
commodities (e.g. oil) onto the final prices is limited12. In addition, in view of fierce competition on the
labour market and the changes referred to above, the risk of growing wage demands is limited, and so
are the so-called second-round effects.
Over the past three decades, the financial sector has become highly international. Financial services,
provided under strictly regulated, separate, domestic financial systems in the past, are now provided
under ever more open, competitive and global system. One of the measures of globalisation in the
financial services sector is the growing volume of cross-border capital flows. Cross-border transactions
in the bonds and shares segment are now exceeding 90 trillion (thousand billion) US dollars per
annum, which translates into USD 250 billion daily13. Moreover, the size of financial markets and their
meaning to the global economy becomes ever greater. According to McKinsey Global Institute14, the
total value of global financial assets is now USD 118 trillion, whilst as far back as in 1980 they were
only 12 trillion. The increase in the volume of financial assets is progressing at a higher rate than that
of output, and has now reached a threefold of the global GDP, whilst back in 1980 it was
approximately equal to the world output. Additionally, the fastest growing segment of the financial
market is the segment of private debt securities. What is more, international issues of these securities
grow at a higher rate than domestic issues, which means that companies increasingly finance their
activities from funds raised abroad. Additionally, an important feature of development of the financial
market is the gradual fall in significance of intermediation of the banking sector with a simultaneous
increase of significance of the market intermediation15. As a consequence, the central banks channels
of influence on the economy are changing. In the past the bank loan channel was deemed more
important; it is now loosing its significance in relative terms.
Until recently, the investment rate in the economy was to a large extent dependent on the domestic
savings rate, which by the way was contradictory to one of the fundamental assumptions of some
economic models of the full integration of capital markets. The economy was featured by the so-called
home bias i.e. greater inclination of domestic investors to invest in domestic assets rather than in
foreign assets16. The latest research17 suggests that home bias over the past years could have
dropped significantly, at least in the OECD countries. The decrease may be attributed to the very
growth of cross-border capital flows. What does that mean to the monetary policy? If domestic and
foreign financial assets are treated more and more as perfect substitutes, domestic interest rates,
especially mid- an long-term ones, are determined on the global market, and thus the influence of
particular central banks on their level is weakened. This phenomenon is already observed in the USA.
12 Melick W., Galati G. "The Evolving Inflation Process: an Overview", BIS Working Paper No 196, 2006.
13 Hannoun H. "Internationalisation of financial services: implications and challenges for central banks", Conference of the
SEACEN Governors Bandar Seri Begawan, Brunei Darussalam, 4 March 2006.
14 McKinsey Global Institute, $118 Trillion and Counting: Taking Stock of the Worlds Capital Markets, February 2005.
15 In 1980 bank deposits accounted for 45% of total financial assets, currently their share dropped to 30% (McKinsey Global
Institute 2005 ibidem).
16 It is called the Feldstein-Horioka puzzle, after the two economists, who were the first to empirically prove its existence
17 Feldstein M. Monetary Policy in a Changing International Environment: The Role of Capital Flows, NBER Working Paper
6 BIS Review 57/2006
Although the key interest rate of the central bank has been raised from 1.00% in 2004 to 4.75% at
present (i.e. by 3.75 percentage points), long-term interest rates, which are more important from the
aggregate demand perspective, have remained roughly unchanged18. As a result, the effect of
tightening the monetary policy on the aggregate demand has been significantly contained due to lack
of response from long-term interest rates.
In the world of global financial markets nobody seems to be surprised by the fact that during the
session of the Federal Open Market Committee (FOMC19) of the American Federal Reserve, the eyes
of the entire financial market are fixed on its Chairman. Why is that? Decisions made by the FOMC in
Washington are equally as important for investors in New York as those in London, Tokyo, Rio de
Janeiro, Shanghai or even Warsaw. Not only do the FOMC decisions influence US economy, but also
- via the financial markets channel - the entire global economy. An unexpected increase in interest
rates in the USA may bring about a sudden outflow of capital from the emerging markets, and thus
weaken the currencies of those countries and increase their bond yields.
Some economists20 make the point that an important aspect of the growing internationalisation of
financial markets is increased discipline, which is extorted by investors on governments and central
banks in individual countries. According to this hypothesis, the financial markets, through their
continuous valuation of securities, duly reward good and punish bad economic policies. However, the
empirical results do not provide hard evidence to support the thesis on fiscal policy discipline. It may
be stated, on the other hand, that financial globalisation may have contributed to the discipline of
central banks and to "forcing" them to conduct a monetary policy focused on low and stable inflation21.
At the same time, a significant risk related to the financial markets integration is the possibility to shift
economic problems of one country upon other countries, which is greater than before (the contagion
effect). Between 1997 and 1998, countries of South-East Asia experienced this effect, when all of a
sudden capital flew out, bringing about financial crisis in economy after economy, which could not be
prevented by either the monetary or exchange rate policy.
One of the vital dimensions of globalisation is the fast spreading of knowledge, technology and knowhow.
The flow of know-how also applies to the public sector, including the central bank. One of the
features of modern central banking is gradual homogenisation of the strategies applied to the
monetary policy. Since 1990, when for the first time the central bank of New Zealand started to
implement the strategy of direct inflation targeting (DIT), over 20 central banks followed and adopted
that strategy. As a result, the DIT strategy (applied since 1998 by the NBP) is now the dominating
strategy of the monetary policy, applied by the majority of central banks in developed countries22, and
more and more, by central banks of the developing countries (such as Turkey, the Philippines, Ghana,
Romania and Armenia). A bloom of the DIT strategy endorses the observation that central banks
adopt the "technology" of low and stable inflation from one another.
The dissemination of the DIT strategy was accompanied by a decrease in the average inflation level,
especially in the developing countries that lowered inflation from a high level. This may prove that the
dissemination of the DIT strategy was one of the factors that have contributed to disinflation.
Admittedly, the impact of the DIT strategy on lowering inflation is a subject matter of discussion23;
however, empirical evidence exists that implementation of the DIT strategy improves macroeconomic
18 This is even called the Greenspans conundrum, after the name of the former Chairman of the US Federal Reserve.
19 FOMC (Federal Open Market Committee): the decision-making authority on interest rates in the Management Board of the
US Federal Reserve.
20 Hannoun H. ibidem.
21 Tytell I., Wei S-J. "Does Financial Globalization Induce Better Macroeconomic Policies?", IMF Working Paper 04/84, May
22 The DIT strategy is applied in most developed countries outside the euro area and the USA. However, in the case of the
euro area, one may talk of thede facto DIT strategy, and in the case of the USA the current Chairman, Fed Ben
Bernanke, is a zealous DIT enthusiast, so its implementation in the USA soon is not out of question.
23 See e.g. "Does Inflation Targeting Matter?" Ball L., Sheridan N. in: "The Inflation-Targeting Debate" Bernanke B.S.,
Woodford M. (2005).
BIS Review 57/2006 7
outcomes (lower costs of stabilising inflation, decreased influence of price shocks and output shocks
on inflation, thereby - decreased effect of past inflation on the current inflation, which reduces inflation
persistence)24. Empirical research also suggests that the DIT strategy facilitates stabilisation of longterm
An additional result of dissemination of the DIT strategy is elaboration of standards of communication
in conducting the monetary policy (announcements of decision-making authorities, inflation reports
and published inflation projections), which facilitate contacts of the central bank with the external
environment (the financial market and the general public). It may be speculated that these standards
make the interpretation of the decisions made by the central bank easier for foreign investors, which
should, under the huge cross-border capital flows, increase the effectiveness of the monetary policy in
As mentioned before, the process of globalisation is a serious challenge for central banks. Following
the increase in human workforce relatively to the capital resource, the pay of the workforce has gone
down, and so did the costs of manufacturing of many goods and services. Setting fuel prices apart,
whose increase is also brought about by globalisation, inflation in many countries remains very low,
whereas a strong increase in the global labour supply mitigates the possibility of occurrence of the
second-round effects i.e. wage increases in response to a rise in current inflation. On the other hand,
the global surplus of savings over investments causes the capital to chase the high yield opportunities,
thus increasing asset prices in many countries. An exemplary case may be increases in stock
exchange indices, bond prices or real property prices in Anglo-Saxon countries and e.g. in Spain. As a
logical consequence, a question arises about how the monetary policy should be conducted in these
circumstances, and in particular, whether it should respond to the increase in asset prices despite the
fact that inflation of consumer goods and services remains low or very low. Another vital question
arises about the appropriate level of central bank interest rates when long-term interest rates remain
low, possibly as a result of globalisation. A hot debate accompanies the issue, both among the central
bankers26 and among academics.27
The Chairman of the Federal Reserve, Ben Bernanke, in his address28 last month, presented possible
diagnoses regarding the sources of low interest rates on the bond market despite as many as fourteen
increases in the central bank references rates. There are at least two explanations of such situation. If
the long-term interest rates remain unchanged and the short-term ones increase, this means that
either the markets pessimistically assess the perspectives of economic growth or the risk premium
related to forward rates decreases; here this may be the inflation risk premium or real interest rates
volatility risk premium. Another explanation may be the very effect of global imbalances, i.e. the result
of large purchases of sovereign bonds by Asian central banks and oil- exporting countries. Depending
on which hypothesis is true, the implications for the monetary policy are different. If the long-term rates
go down as a result of poor growth prospects, the current short-term interest rates should be lowered
respectively so as to prevent possible deflation. If, however, specific factors related to globalisation or
decrease in the risk premium are the cause of persisting low long-term interest rates, the short-term
interest rate should be higher in order to achieve appropriate restrictiveness of the monetary policy
24 See Corbo V., Landerretche O., Schmidt-Hebbel K. "Does Inflation Targeting Make a Difference" in: N. Loayza and R. Soto
(red.) "Inflation Targeting: Design, Performance, Challenges" (Central Bank of Chile: Santiago 2002).
25 Gürkaynak R.S., Levin A.T., Marder A.N., Swanson E.T. "Inflation Targeting and the Anchoring of Inflation Expectations in
the Western Hemisphere",forthcoming in Mishkin, Frederic and Klaus Schmidt-Hebbel (red.), Series on Central Banking,
Analysis and Economic Policies X: Monetary Policy under Inflation Targeting (Santiago, Chile: Banco Central de Chile),
2006 and Gürkaynak R.S., Levin A.T. Swanson E.T. "Does Inflation Targeting Anchor Long-Run Inflation Expectations?
Evidence from Long-Term Bond Yields in the U.S., U.K., and Sweden", Federal Reserve Bank of San Francisco Working
Paper 2006-09, March 2006.
26 For example a question whether monetary policy should burst asset bubbles was hotly debated during the large European
Central Bank conference on 16 to17 March 2006.
27 The examples are the following articles: N. Roubini "Why Central Banks Should Burst Bubbles", mimeo, Stern School of
Business and Roubini Global Economics, January 2006, and A. Posen "Why Central Banks Should Not Burst Bubbles",
Institute for International Economics Working Paper WP 06-1, January 2006.
28 Bernanke B. "Reflections on the Yield Curve and Monetary Policy", Remarks by Chairman Ben S. Bernanke Before the
Economic Club of New York, 20 March 2006.
8 BIS Review 57/2006
resulting from the entire yield curve. While it is difficult to assess which hypothesis is correct, central
banks, as sailors did in the old days, should apply two iron rules: firstly, frequently determine their
position, secondly, use as many waypoints as possible. This means that, especially where new
phenomena emerge or there are structural transformations, the monetary policy must not be described
using just a few simple indicators, as e.g. inflation and output gap in the Taylor rule. Monetary policy
decisions should rather be a product of a complex analysis of a number of indicators and data and cross-checked with qualitative information.
In turn, another Federal Reserve governor, Donald Kohn29,
devoted his recent address to the analysis
of when and on what conditions the central banks should respond to rapid changes of asset prices.
In Kohns opinion, there are two possible approaches.
According to one of them, described as the conventional monetary policy,
the central bank focuses on stabilising the inflation, treats changes in
asset prices as an exogenous process and does not attempt to influence asset prices whatsoever. The
other option, described by Kohn as the "extra action policy",
allows for a deviation of current inflation
from a level determined as stable in return for improvement of the perspectives of achieving price
stability in the future. However, the extra action policy does not mean piercing the speculative bubbles
by central banks, and means rather "taking out" of additional insurance against possible negative
shocks, which may happen in the future.
In Kohns opinion, the extra action policy may be run very
rarely and only where the three conditions are met:
the central bank must be able to identify asset bubbles in a timely manner and high certainty
as to the correctness of analysis conclusions;
there must be a high probability that a slight tightening of the monetary policy will be able to
stand against the speculative activity on a given assets market;
the expected improvement of the future economic situation resulting from a smaller
speculative bubble must be significant and higher than the costs incurred by the economy in
the aftermath of running the extra action policy.
To recapitulate this train of thought, Kohn was very sceptical whether the three above-mentioned
conditions can be sufficiently met; however, he did not preclude that in the future, the understanding of
economic processes will improve as much as to enable running the extra action policy where
reasonable. Numerous statements following the presentation have indicated that the proper
supervision is much better a response to the asset bubbles and many people have stressed that this is
why the financial markets supervision should be independent of politicians, as it may be necessary to
take actions aimed to restrict the speed of the speculative bubbles build-up , when this does not suit certain politicians due to the elections cycle.
The majority of lectures which are delivered over the series of seminars by the Centre for European
Regional and Local Studies and the UNESCO Chair at Warsaw University apply to the issues vital for
local communities. The title of todays seminar might suggest that we have discussed problems vital
for the global economy and not for a local community, a city, a region or a university/higher education institution.
This is not the case, however, as in the years to come the globalisation of manufacturing,
services, investments, finances, the labour market and knowledge will progress, irrespective of the
scale of national protectionism. The globalisation results will be thus felt by all: countries, regions, local
communities and individuals.
If we want to succeed, both as a country and as each and every one of
us, we must be well prepared for globalisation.
Thank you very much for your attention.
Kohn "Remarks by Donald Kohn at Monetary Policy:
A Journey from Theory to Practice,
An ECB Colloquium held in honor of Otmar Issing",
16 March 2006.
BIS Review 57/2006 9
Ben S Bernanke: Energy and the economy
Remarks by Mr Ben S Bernanke,
Chairman of the Board of Governors
of the US Federal Reserve System,
before the Economic Club of Chicago,
Chicago, 15 June 2006.
* * *
In my remarks today, I would like to discuss the relationship between energy markets and the
economy. As I am certain all of you are aware, the steep increases in energy prices over the past
several years have had significant consequences for households, businesses, and economic policy. At
least since the time of the first oil shock in October 1973, economists have struggled to understand the
ways that disturbances to the supply and demand balance in energy markets influence economic
growth and inflation. At the most basic level, oil and natural gas are just primary commodities, like tin,
rubber, or iron ore. Yet energy commodities are special, in part because they are critical inputs to a
very wide variety of production processes of modern economies. They provide the fuel that drives our
transportation system, heats our homes and offices, and powers our factories. Moreover, energy has
an influence that is disproportionate to its share in real gross domestic product (GDP) largely because
of our limited ability to adjust the amount of energy we use per unit of output over short periods of
time. Over longer periods, energy consumption can be altered more easily by, for example, adjusting
the types of vehicles that we drive, the kind of homes that we build, and the variety of machines that
we buy. Those decisions, in turn, influence the growth and composition of the stock of capital and the
productive capacity of the economy.
Over the past thirty-five years, the U.S. economy has experienced some wide swings in energy prices.
The oil price increases of the 1970s were followed by price declines in the mid-1980s and then a price
spike in 1990, with numerous fluctuations since then. From the mid-1980s until fairly recently, market
participants tended to look through these price cycles and did not allow their longer-term expectations
for oil prices to be greatly affected by short-run swings in spot prices. But beginning around 2003,
futures prices began moving up roughly in line with the rise in spot prices. Thus, unlike in earlier
episodes, the significantly higher relative price of energy that we are now experiencing is expected to
be relatively long lasting and thus will likely prompt more-significant adjustments by households and
businesses over time.
This higher relative price of energy poses many important questions for economists and policymakers.
Why have the prices of oil and natural gas risen so much? What is the outlook for energy supplies and
prices in the medium term and in the long term? And what implications does the behavior of energy
prices have for the ongoing economic expansion and inflation? I will touch briefly on each of these
Developments in oil markets
Let me begin with the market for crude oil. What accounts for the behavior of the current and expected
future prices of petroleum? Supply and demand are among the most valuable concepts in the
economist's toolkit, and I believe they are the key to understanding recent and prospective
developments in oil markets. For the most part, high oil prices reflect high and growing demand for oil
and limited and uncertain supplies.
On the demand side, world oil consumption surged 4 percent in 2004 after rising a solid 2 percent in
2003. The rise in 2004 was much larger than had been expected and was, in fact, the largest yearly
increase in a quarter-century. A significant part of the unexpected increase in oil consumption that
year reflected rapidly growing oil use in the United States and East Asia, notably China. In 2005,
growth of world oil consumption slowed to 1.3 percent, partly reflecting the restraining effects of higher
prices. Nonetheless, the level of oil consumption was still high relative to earlier expectations. Thus far
this year, underlying demand pressures have remained strong in the context of a global economy that
has continued to expand robustly.
On the supply side, the production of oil has been constrained by available capacity, hurricanes, and
geopolitical developments. In 2003 and 2004, as oil consumption and prices rose briskly, Saudi Arabia
and other members of the Organization of the Petroleum Exporting Countries (OPEC) pumped more
oil. OPEC was able to boost production relatively quickly in response to changing market conditions by
utilizing productive capacity that had been idle. By the end of 2004, however, OPEC's spare
BIS Review 56/2006 1
production capacity was greatly diminished. As a consequence, OPEC's oil production flattened out
over the past year even as oil prices continued to soar.
Oil production outside OPEC also leveled off last year, contrary to earlier expectations for continued
growth. This development in part reflected the devastating effects of last year's hurricanes. Katrina
and Rita were enormously disruptive for our nation's production of energy. At the worst point, 1.5
million barrels per day of crude oil were shut in, virtually all of the U.S. production in the Gulf of Mexico
and nearly 2 percent of global oil production. Recovery of oil production in the Gulf has been slow, and
the disruptions from last year's storms linger even as we enter this year's hurricane season. The
cumulative loss in oil production attributable to Katrina and Rita amounts to more than 160 million
barrels of oil, a figure equivalent to nearly half the present level of commercial crude oil inventories in
the United States.
With the background of strong demand and limited spare capacity, both actual production disruptions
and concerns about the reliability and security of future oil supplies have contributed to the volatility in
oil prices. The oil-rich Middle East remains an especially unsettled region of the world, but political
risks to the oil supply have also emerged in nations outside the Middle East, including Russia,
Venezuela, and Nigeria.
Compounding these difficulties in markets for crude oil have been constraints and disruptions in the
refining sector of the energy industry. In the wake of Hurricane Rita, one-quarter of domestic refining
capacity was offline, and here, too, the period of recovery has been protracted. Even before last year's
hurricanes, however, a mismatch appeared to be emerging between the incremental supply of crude
oil, which tended to be heavy and sulfurous, and the demand by refiners for light, sweet crude, which
can be converted more easily into clean-burning transportation fuels. These developments have
highlighted the need for additional investments in refining capacity to bridge the gap between
upstream supply and final demand.
What about the longer term? We can safely assume that world economic growth, together with the
rapid pace of industrialization in China, India, and other emerging-market economies, will generate
increasing demand for oil and other forms of energy. In all likelihood, growth in the demand for energy
will be tempered to some extent by continued improvements in energy efficiency which, in turn, will be
stimulated by higher prices and ongoing concerns about the security of oil supplies. Such
improvements are possible even without technological breakthroughs. For example, Japan is an
advanced industrial nation that uses only about one-half as much energy to produce a dollar's worth of
real output as the United States does. Of course, the Japanese and U.S. economies differ in important
ways, but the comparison nevertheless suggests that there is scope to boost energy efficiency in the
United States and other parts of the industrialized world. Newly industrializing economies such as
China appear to be quite inefficient in their use of energy; but as they modernize, they can adopt
energy-saving techniques already in use elsewhere, and their energy efficiency will presumably
improve as well.
Still, as the global economic expansion continues, substantial growth in the use of oil and other energy
sources appears to be inevitable. How readily the supply side of the oil market will respond is difficult
to predict. In a physical sense, the world is not in imminent danger of running out of oil. At the end of
2005, the world's proved reserves of conventional oil - that is, oil in the ground that is viewed as
recoverable using existing technologies and under current economic conditions - stood at more than
1.2 trillion barrels, about 15 percent higher than the world's proved reserves a decade earlier and
equal to about four decades of global consumption at current rates. These figures do not include
Canada's vast deposits of oil sands, which are estimated to contain an additional 174 billion barrels of
proved reserves. In addition, today's proved reserve figures ignore not only the potential for new
discoveries but also the likelihood that improved technologies and higher oil prices will increase the
amount of oil that can be economically recovered.
The oil is there, but whether substantial new sources of production can be made available over the
next five years or so is in some doubt. Some important fields are in locations that are technically
difficult and time-consuming to develop, such as deep-water fields off the coast of West Africa, in the
Gulf of Mexico, or off the east coast of South America. In many cases, the development of new fields
also faces the challenge of recovering the oil without damaging delicate ecosystems. Perhaps most
troubling are the significant uncertainties generated by geopolitical instability, as I have already noted.
Much of the world's oil reserves are located in areas where political turmoil and violence have
restrained both production and investment.
BIS Review 56/2006 2
In both the developed and the developing world, another factor holding back investment in oil
infrastructure has been concern on the part of producers that oil prices might fall back as they did in
the 1980s and 1990s. In light of that recognition, some oil producers have been reluctant to launch
exploration projects even with today's high prices. Such concerns have been reinforced by the huge
reserves of oil in several OPEC countries that could be extracted at very low cost if sufficient
resources and expertise were directed toward doing so.
Developments in the natural gas market
The story for natural gas shares some similarities with the story for oil, but there are important
differences as well. In the 1990s, the U.S. spot price of natural gas at the Henry Hub averaged about
$2 per million Btu. However, in recent years, the United States has seen a marked increase in the
price of natural gas. The average spot price climbed to nearly $9 per million Btu in 2005, with the price
spiking to $15 per million Btu following hurricanes Katrina and Rita. So far this year, natural gas prices
have fallen back to around $7 per million Btu as an unusually warm winter curtailed consumption and
boosted natural gas in storage to record levels. Futures markets currently anticipate that the price of
natural gas will be about $9 per million Btu next year.
Why have natural gas prices risen so sharply over the past few years, and why are they expected to
remain elevated? As with oil, high prices of natural gas reflect strong demand and diminished supplies.
Unlike the globally integrated market for oil, however, natural gas markets are regional, primarily
because of the difficulty in transporting gas by means other than pipelines. Although the world's
capacity to trade liquefied natural gas, which is transported by ships, is growing, it is still a small
fraction of world supply and is not yet sufficient to fully integrate natural gas markets across
continents. Demand for natural gas in North America has remained strong in recent years, particularly
as environmental concerns have led clean-burning natural gas to become the fuel of choice for new
electricity generation. Moreover, increases in oil prices have boosted the demand for energy
substitutes such as natural gas. However, domestic production of natural gas has not kept up. Last
year, U.S. production was 7 percent below its 2001 level, with less than half of that decline reflecting
the impact of hurricanes Katrina and Rita.
Increased trade can often mitigate price increases, but net imports of natural gas from Canada, which
currently account for around 16 percent of U.S. consumption, have failed to increase in response to
higher prices. Between 1988 and 2001, net imports from Canada tripled, but they have since flattened
out. Both U.S. and Canadian gas fields have matured and are yielding smaller increases in output,
despite the incentive of high prices and a substantial increase in the number of drilling rigs in
Trade in liquefied natural gas, or LNG, is also likely to increase over time, but perhaps at a slower
pace than once envisioned. LNG imports into the United States nearly tripled from 2002 to 2004, but
they actually fell a bit last year as production disruptions in a number of countries limited supply and as
consumers in other countries competed for available cargoes.
Thus, natural gas prices are likely to remain elevated for at least the coming few years. It is possible,
however, that within a decade new supplies from previously untapped areas of North America could
boost available output here, while imports of LNG will increase to more substantial levels as countries
seek to bring their isolated natural gas reserves to market. Given time, these developments could
serve to lower natural gas prices in the United States significantly. Nonetheless, because of the higher
costs of producing these supplies relative to the traditional sources of natural gas, as well as the
elevated cost of other energy sources such as oil, natural gas prices seem unlikely to return to the
level of the 1990s.
Thus, the supply-demand fundamentals seem consistent with the view now taken by market
participants that the days of persistently cheap oil and natural gas are likely behind us. The good news
is that, in the longer run, we have options. I have already noted the scope for improvements in energy
efficiency and increased conservation. Considerable potential exists as well for substituting other
energy sources for oil and natural gas, including coal, nuclear energy, and renewable sources such as
bio-fuels and wind power. Given enough time, market mechanisms are likely to increase energy
supplies, including alternative energy sources, while simultaneously encouraging conservation and
substitution away from oil and natural gas to other types of energy.
BIS Review 56/2006 3
Economic and policy implications of increased energy prices
What are the economic implications of the higher energy prices that we are experiencing? In the long
run, higher energy prices are likely to reduce somewhat the productive capacity of the U.S. economy.
That outcome would occur, for example, if high energy costs make businesses less willing to invest in
new capital or cause some existing capital to become economically obsolete. All else being equal,
these effects tend to restrain the growth of labor productivity, which in turn implies that real wages and
profits will be lower than they otherwise would have been. Also, the higher cost of imported oil is likely
to adversely affect our terms of trade; that is, Americans will have to sell more goods and services
abroad to pay for a given quantity of oil and other imports. For the medium term at least, the higher bill
for oil imports will increase the U.S. current account deficit, implying a greater need for foreign financing.
Under the assumption that energy prices do not move sharply higher from their already high levels,
these long-run effects, though clearly negative, appear to be manageable. The U.S. economy is
remarkably flexible, and it seems to have absorbed the cost shocks of the past few years with only a
few dislocations. And conservation and the development of alternative energy sources will, over the
long term, ameliorate some of the effects of higher energy prices. Moreover, ongoing productivity
gains arising from sources such as technological improvements are likely to exceed by a significant
margin the productivity losses created by high energy prices.
In the short run, sharply higher energy prices create a rather different and, in some ways, a more
difficult set of economic challenges. Indeed, a significant increase in energy prices can simultaneously
slow economic growth while raising inflation.
An increase in oil prices slows economic growth in the short run primarily through its effects on
consumer spending. Because the United States imports much of the oil that it consumes, an increase
in oil prices is, as many economists have noted, broadly analogous to the imposition of a tax on U.S.
residents, with the revenue from the tax going to oil producers abroad. In 2004 as a whole, the total
cost of imported oil increased almost $50 billion relative to 2003. The imported oil bill jumped again
last year by an additional $70 billion, and given the price increases we have experienced in 2006, it
appears on track to increase $50 billion further at an annual rate in the first half of this year. Coupled
with the rising cost of imported natural gas, the cumulative increase in imported energy costs since the
end of 2003 is shaping up to be $185 billion - equal to almost 1-1/2 percent of GDP. All else being
equal, this constitutes a noticeable drag on real household incomes and spending. It is a tribute to the
underlying strength and resiliency of the U.S. economy that it has been able to perform well despite
the drag from increased energy prices.
At the same time that higher oil prices slow economic growth, they also create inflationary pressures.
Higher prices for crude oil are passed through to increased prices for the refined products used by
consumers, such as gasoline and heating oil. When oil prices rise, people may try to substitute other
forms of energy, such as natural gas, leading to price increases in those alternatives as well. The rise
in prices paid by households for energy - for example for gasoline, heating oil, and natural gas -
represent, of course, an increase in the cost of living and in price inflation. This direct effect of higher
energy prices on the cost of living is sometimes called thefirst-round effect on inflation. In addition,
higher energy costs may have indirect effects on the inflation rate - if, for example, firms pass on their
increased costs of production in the form of higher consumer prices for non-energy goods or services
or if workers respond to the increase in the cost of living by demanding higher nominal wages. A jump
in energy costs could also increase the public's longer-term inflation expectations, a factor that would
put additional upward pressure on inflation. These indirect effects of higher energy prices on the
overall rate of inflation are calledsecond-round effects.
The overall inflation rate reflects both first-round and second-round effects. Economists and
policymakers also pay attention to the so-called core inflation rate, which excludes the direct effects of
increases in the prices of energy (as well as of food). By stripping out the first-round inflation effects,
core inflation provides a useful indicator of the second-round effects of increases in the price of energy.
In the past, notably during the 1970s and early 1980s, both the first-round and second-round effects of
oil-price increases on inflation tended to be large, as firms freely passed on rising energy costs to
consumers, workers reacted to the surging cost of living by ratcheting up their wage demands, and
longer-run expectations of inflation moved up quickly. In this situation, monetary policymaking was
extremely difficult because oil-price increases threatened to result in a large and persistent increase in
the overall inflation rate. The Federal Reserve attempted to contain the inflationary effects of the oil-
BIS Review 56/2006 4
price shocks by engineering sharp increases in interest rates, actions which had the consequence of
sharply slowing growth and raising unemployment, as in the recessions that began in 1973 and 1981.
Since about 1980, however, the Federal Reserve and most other central banks have worked hard to
bring inflation and expectations of inflation down. An important benefit of these efforts is that the
second-round inflation effect of a given increase in energy prices has been much reduced. To the
extent that households and business owners expect that the Fed will keep inflation low, firms have
both less incentive and less ability to pass on increased energy costs in the form of higher prices, and
likewise workers have less incentive to demand compensating increases in their nominal wages.
As I noted in remarks last week, although the rate of pass-through of higher energy and other
commodity prices to core consumer price inflation appears to have remained relatively low in the
current episode - reflecting the inflation-fighting credibility built by the Fed in recent decades the
cumulative increases in energy and commodity prices have been large enough that they could
account for some of the recent pickup in core inflation. In addition, some survey-based measures of
longer-term inflation expectations have edged up, on net, in recent months, as has the compensation
for inflation and inflation risk implied by yields on nominal and inflation-indexed government debt. As
yet, these expectations measures have remained within the ranges in which they have fluctuated in
recent years and inflation compensation implied by yields on government debt has fallen back
somewhat in the past month. Nevertheless, these developments bear watching.
In conclusion, energy prices have moved up considerably since the end of 2002,
reflecting supply and demand factors.
In the short run, prices are likely to remain high in an environment of strong world
economic growth and a limited ability to increase energy supplies.
Moreover, prices are likely to be volatile in the near term,
given the small margins of excess capacity to produce crude oil or natural gas
that traditionally have buffered short-run shifts in supply and demand.
However, in the long run, market forces will respond.
The higher relative prices of energy will createincentives for businesses to create new,
energy-saving technologies and for energy consumers to adopt them.
The market for alternative fuels is growing rapidly and will help to shift consumption away
from petroleum-based fuels.
Government can contribute to these conservation efforts by working tocreate a regulatory environment that encourages the growth in energy supplies in a manner that is consistent with our nation's environmental and other objectives.
Given the extraordinary resilience of the U.S. economy,
I am confident our nation will be up to this challenge.
BIS Review 56/20065
BIS Review Nos.56 & 57
June 22, 2006