We have been watching closely the recent volatility in global financial markets. Our sense is that at this stage these developments do not pose a substantial risk to the U.S. economic outlook. We will, of course, continue to monitor the situation.

When the recent financial crisis in the United States and other advanced economies threatened to spill over to Mexico, the inflation credibility enjoyed by the Bank of Mexico allowed it to counter economic weakness by easing monetary conditions, even though headline inflation was running above its target range at the time. The Bank's rate cuts helped stabilize the economy, and Mexican output returned to its pre-crisis level by late 2010. Strong countercyclical policy actions of this type were unlikely to have been feasible in Mexico a few decades ago; with little in the way of inflation-fighting credibility and an immature financial sector, the monetary authority in earlier years was often forced to respond to a crisis by tightening monetary conditions, rather than loosening them, in an effort to limit capital flight, exchange rate depreciation, and increases in inflation.

Of course, heavy capital inflows and their volatility pose challenges to emerging market policymakers, whatever their source. Policymakers do have some tools to address these concerns. In recent years, emerging market nations have implemented macroprudential measures aimed at strengthening their financial systems and reducing overheating in specific sectors, such as property markets. Policymakers have also experimented with various forms of capital controls. Such controls raise concerns about effectiveness, cost of implementation, and possible microeconomic distortions. Nevertheless, the International Monetary Fund has suggested that, in carefully circumscribed circumstances, capital controls may be a useful tool.

In particular, some critics have argued that the Fed's asset purchases, and accommodative monetary policy more generally, encourage capital flows to emerging market economies. These capital flows are said to cause undesirable currency appreciation, too much liquidity leading to asset bubbles or inflation, or economic disruptions as capital inflows quickly give way to outflows.

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[T]he perceived benefits of currency management inevitably come with costs, including reduced monetary independence and the consequent susceptibility to imported inflation. In other words, the perceived advantages of undervaluation and the problem of unwanted capital inflows must be understood as a package--you can't have one without the other.

Of course, an alternative strategy--one consistent with classical principles of international adjustment--is to refrain from intervening in foreign exchange markets, thereby allowing the currency to rise and helping insulate the financial system from external pressures. Under a flexible exchange-rate regime, a fully independent monetary policy, together with fiscal policy as needed, would be available to help counteract any adverse effects of currency appreciation on growth. The resultant rebalancing from external to domestic demand would not only preserve near-term growth in the emerging market economies while supporting recovery in the advanced economies, it would redound to everyone's benefit in the long run by putting the global economy on a more stable and sustainable path.

On balance, stronger US growth is beneficial for the entire global economy,” Yellen said at a panel at the IMF annual meeting.

She said that “developing countries do have tools” – principally a looser fiscal and monetary policy – to offset any negative economic impact from a stronger currency. “Interest-rate differentials do drive capital flows and [this] undoubtedly puts press on exchange rates [but] it is not the Fed’s intention to make things more difficult,” she said, acknowledging the political fallout from the Fed’s latest round of asset purchases.

Notably, in recent months, some officials in emerging market economies and elsewhere have argued that accommodative monetary policies in the advanced economies, especially the United States, have been producing negative spillover effects on their economies. In particular, they are concerned that advanced economy policies are inducing excessive capital inflows to the emerging market economies, inflows that in turn put unwelcome upward pressure on emerging market currencies and threaten to create asset price bubbles...

To a large degree, these capital flows have been driven by perceived return differentials that favor emerging markets, resulting from factors such as stronger expected growth--both in the short term and in the longer run--and higher interest rates, which reflect differences in policy settings as well as other forces....

Given these advantages of a system of market-determined exchange rates, why have officials in many emerging markets leaned against appreciation of their currencies toward levels more consistent with market fundamentals? The principal answer is that currency undervaluation on the part of some countries has been part of a long-term export-led strategy for growth and development. This strategy, which allows a country's producers to operate at a greater scale and to produce a more diverse set of products than domestic demand alone might sustain, has been viewed as promoting economic growth and, more broadly, as making an important contribution to the development of a number of countries. However, increasingly over time, the strategy of currency undervaluation has demonstrated important drawbacks, both for the world system and for the countries using that strategy.

Some observers have concluded, first, that the United States is able to borrow on highly advantageous terms to finance its external deficits and, second, that the United States receives a much higher return on its foreign investments than other countries receive on their investments in the United States. Some novel theories have been developed to support these interpretations. Recent work by Federal Reserve staff, however, has shown that one need not resort to such exotic explanations to understand the behavior of the international accounts. Instead, a careful look at the published data reveals that differences in the three characteristics of U.S. claims and liabilities that I just discussed--returns, composition, and size--contain the key to understanding these apparently anomalous results and, hence, that the United States faces a “reality” similar to that of other countries.

there is not much evidence that investors or holders of foreign reserves have shifted in any serious way out of the dollar to this point. And, indeed, we've seen a lot of flows into U.S. treasuries, which is one of the reasons why the rates of short-term U.S. treasuries are so low, reflecting their safety, liquidity and general attractiveness to international investors.

From the Q&A session

I believe that the current net flow of capital toward the industrial world is not in the long-term interest of the developing economies. To raise incomes and reduce poverty, the developing economies must boost their productivity, and that, in turn, will require complementing their large and growing labor forces with increasing quantities of capital.

Let's begin by getting some sense of the size, source, and composition of the net capital flows that are moving from developing to industrial countries.  One reasonable measure of the size of these flows is the combined current account balance of the developing economies.  According to estimates by the International Monetary Fund (IMF), the developing economies as a group had a current account surplus of $640 billion last year (IMF, 2007a).³  Because the financial counterpart to this surplus is a deficit on the financial accounts, it represents the net capital outflow to the industrial economies.  $640 billion is a big number and stands in sharp contrast to the situation preceding the Asia crisis.  For example, in 1996 the combined current account balance of the developing economies was a deficit of $80 billion, representing a capital inflow of that amount from the industrial world.

The sources of the $640 billion in net capital flow out of the developing economies are remarkably concentrated.  Of those developing economies running current account surpluses, a mere seventeen of them--China, four other Asian economies, Russia, and eleven members of the Organization of Petroleum Exporting Countries--accounted for a combined surplus of $710 billion.  And about half of that was generated by the major oil-exporting countries in the Middle East and by Russia, whose surpluses ballooned in the past several years as oil prices soared.  Thus, the other 131 developing economies in our data had a combined current account deficit, or net capital inflow, of $70 billion.  This is not to say that things have not changed for these 131 countries in the past decade:  In 1996, their combined current account deficit was twice as large as it was last year.

Third, liquidity in U.S. markets also increased significantly in recent years due to increased international capital flows. These flows to the United States from global investors lead to higher liquidity by increasing capital available for investment and facilitating greater transfer and insurability of risk. A recent report by McKinsey & Company estimated that aggregate international capital flows amounted to $6 trillion in 2005--almost triple the volume a decade earlier--and that one-quarter of the worldwide volume flowed through the United States.

The savings glut story helps to explain the real component of low bond yields as well as the pattern of global capital flows, which was Chairman Bernanke’s focus. Another factor behind declining real yields in some emerging markets is that their improved fiscal situation not only increases national saving but also calms fears about the ability of governments to service their debt.

The emergence of large US trade deficits and corresponding surpluses on the part of our trading partners is, to an important extent, the outcome of market forces.  Several factors, including lingering effects of financial crises in emerging market forces.  Several factors, including the lingering effects of financial crises in emerging market economies and concerns abou the outlook for growth in some industrial economies, have led savings abroad to exceed investment.  This excess saving has been attracted to the United States by our favorable investment climate, strong productivity growth, and deep financial markets.  Although the US net external debt has been growing as a consequence of these inflows, as a fraction of our nation's income it remains within international and historical norms.  Given the strength and flexibility of our economy, there is every reason to believe that, if changes in the foreign outlook or in the tone of financial markets were to cause a reduction in capital inflows and the trade deficit, economic activity and employment would stay strong.

Even with the broad shift globally to more flexible exchange rates, a substantial part of the world economy now run monetary policy regimes targeted at limiting the variability in their exchange rate against the dollar, or a basket in which the dollar plays a substantial role. Sustaining that objective in the past several years has required a large accumulation of dollar assets...The significant rise in the earnings of the energy exporters, many of whom also run exchange rate regimes that seek to shadow the dollar, has also generated a substantial rise in investments in U.S. assets. A large share of the capital flows to the United States that have financed our current account imbalance come from these official sources. These flows add to other sources of private demand for U.S. assets. At the margin, they put downward pressure on U.S. interest rates and upward pressure on other asset prices. Through this effect, the monetary policy regimes that prevail in parts of the world help explain at least part of the persistence of these anomalies...Research at the Federal Reserve and outside suggests that the scale of foreign official accumulation of U.S. assets has put downward pressure on U.S. interest rates, with estimates of the effect ranging from small to quite significant.

Monetary policy itself cannot sensibly be directed at reducing imbalances, but the past and future evolution of global capital flows will of course matter for monetary policy by virtue of their impact on the outlook for output and inflation.