Modeling the gains if central banks worked together

As central banks around the world sharply raised interest rates to combat post-pandemic inflation, the activity revived an old debate: Could countries achieve a higher welfare gain by explicitly coordinating their monetary actions? Peterson Institute economist Maurice Obstfeld, for example, prominently warned that simultaneous tightening would “collectively go too far and drive the world economy into an unnecessarily harsh contraction.” Former Fed Vice Chair Richard Clarida, meanwhile, expressed skepticism that “additional material, reliable, and robust gains … would flow from a formal regime of binding monetary policy cooperation.”

Minneapolis Fed Monetary Advisor Javier Bianchi and former visiting research economist Louphou Coulibaly (University of Wisconsin–Madison) find substantial gains to monetary cooperation in a new model featuring international financial spillovers (Working Paper No. 802: “Financial Integration and Monetary Policy Coordination”). Depending on economic conditions, they find that central banks operating independently may over- or under-tighten in the Nash equilibrium, relative to a cooperative outcome. As policymakers set rates to maximize the welfare of domestic households, they do not internalize effects on the global real interest rate. These spillover effects on the world rate make it harder for central banks elsewhere to meet their own objectives for output and stabilizing inflation.

The economists find no straight-line connection between the monetary challenge (recession or inflation) and the imbalance that results. Whether the Nash outcome generates under- or over-tightening depends on the interplay of three conditions: the sign of the output gap (recession or overheating), whether an appreciating exchange rate increases or decreases trade deficits (the Marshall-Lerner condition), and the relative labor-factor intensities of tradable and non-tradable sectors.

When multiple countries face excess inflation, for example, central banks will collectively over-tighten if labor intensity is greater in the non-tradable sector and if an appreciation of the currency increases the trade deficit. However, if labor intensity is lower in the non-tradable sector, the opposite result occurs and central banks do not tighten enough. The economists find that with a moderately large inflation shock of 3 percent, the welfare gain from central bank cooperation is greater than 1 percent of output.

In a global recessionary shock, central banks will set rates (and drive their currencies) higher or lower depending on which action will tend to increase the trade deficit. However, the economists find these monetary actions will over- or undershoot the optimal rates as countries pursue the goal simultaneously and amplify pressures on each other. They summarize their findings into grids for reference.

The model’s insights into the three determinants of under- or over-tightening persist through extensions of the model, including a commodity price shock, imperfect labor mobility, and allowing the planner to set policy in anticipation of future shocks.

Explicit international monetary policy coordination, outside of a global financial crisis, remains a highly theoretical notion; Fed Chair Jerome Powell describes the Fed’s current approach as “not coordination, but there’s a lot of information sharing.” Nonetheless, Bianchi and Coulibaly hope this early-stage research “provides general guidelines for concrete policy discussions on monetary policy coordination.”

Read the Minneapolis Fed Working Paper: Financial Integration and Monetary Policy Coordination