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.

...

[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.

"Inflation has been a threat especially for countries with quasi-fixed exchange rates with the dollar," Bullard noted, without mentioning specific countries.

[T]he current international monetary system is a mixture of economies, some with open capital accounts and flexible exchange rates, and others with managed exchange rates, more-restricted capital mobility, and more-limited monetary policy independence. Many of these latter economies also have current account surpluses, in part because authorities have been able to resist currency appreciation, and thus inhibit external adjustment, for prolonged periods. This feature of the international system inhibits the process of global rebalancing and could restrain the current recovery.

We need a system characterized by more open capital accounts, flexible exchange rates, and independent monetary policies. Open capital accounts, supported by appropriate financial supervision and regulation, channel savings to their most productive uses, thereby enhancing welfare. Exchange rate flexibility improves domestic macroeconomic management, allowing countries to pursue independent monetary policies tailored to their individual needs, and limits unwelcome spillovers to other economies. Such a system can also flexibly adapt to changing economic and financial realities as countries develop, technology progresses, and shocks buffet the global economy.

Our current international monetary system does not yet fulfill these objectives.

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.

It is interesting that, just a few years ago, strong countercyclical policy actions of the type taken by Korea would not have been recommended for an emerging market country during a period of crisis, and might not even have been feasible. In earlier crises, foreign investors were not inclined to give emerging market policymakers the benefit of the doubt when they promised low inflation and sustainable fiscal policies. Attempts to support economic activity through conventional expansionary policies thus risked a vicious circle of capital flight, exchange rate depreciation, higher inflation, a worsening balance of payments, and more capital flight. As a result, monetary policymakers in emerging markets often reacted to crises--such as the Asian financial crisis of the late 1990s--by raising rather than lowering policy rates, in order to defend the value of the currency, slow capital flight, and bolster the credibility of monetary policy. Likewise, the scope for fiscal expansion was severely limited by concerns about medium-term fiscal sustainability.

Why was this crisis different? In particular, why was the Bank of Korea able to respond in a countercyclical manner this time, reducing rather than raising the policy rate in response to the downturn? One important difference, of course, was that this crisis originated in advanced economies, not in the emerging market economies. Financial institutions in Korea and other emerging market economies had little direct exposure to structured credit products and other troubled securities and entered the crisis in relatively sound condition.

In addition, following the Asian financial crisis in the late 1990s, Korea and a number of other countries in Asia, Latin America, and elsewhere took decisive steps to strengthen their macroeconomic frameworks and financial systems... 

Improvements in the Bank of Korea's monetary framework served the country well during the crisis and are likely to provide additional benefits in the future. Over the past decade, many emerging market economies, including Korea, have reoriented monetary policy toward domestic price stability and away from a focus on stabilizing exchange rates. The Bank of Korea, indeed, adopted a formal inflation targeting regime in 1998. Since then, the exchange value of the won has become more flexible, inflation has declined to an average of about 3 percent, and--as I have discussed today--the ability of the Bank to conduct appropriate countercyclical monetary policies has increased.

For some economies, a rebalancing of demand toward domestic sectors will require significant changes in relative prices, and hence more flexible exchange rates will need to be part of the equation. These measures will not be undertaken solely to satisfy the ethereal principle of global rebalancing enunciated at countless meetings in international policy circles; instead, these measures will be undertaken because they are in the best interests of the countries themselves. In particular, more flexible exchange rates will help domestic demand fill in the gap left once foreign demand falls back to a more sustainable level. More flexible exchange rates also provide domestic policymakers greater scope to focus on domestic goals of full employment and price stability.

I think the -- most economists agree that {China's} currency is undervalued and has been used to promote a more export-oriented economy.

I think it would be good for the Chinese to allow more flexibility in their exchange rate. It would give them more autonomy in their monetary policy so they could address inflation and bubbles within their own economy. And I think that they should combine -- it would be in their interests also to combine a more flexible exchange rate with other efforts to increase domestic demand, domestic consumption and achieve a more balanced economy

There are many countries around the world that don't have market-determined currencies. There is no country as big as China and as integrated as they are into the global economy in terms of goods and services. And so in some ways it's an unnatural act.

During Q&A session

As our global economy becomes more intertwined and complex, the nature and transmission of business cycles and the associated policy responses will no doubt continue to evolve. Economies benefit from having independent monetary policies that provide room to respond flexibly to alternative configurations of economic and financial shocks. These benefits could be increased if exchange rate flexibility were to become more widespread and monetary policies given greater latitude to respond to shocks wherever they originate.

China has officially recognized the need to increase its domestic spending and scale back its reliance on exports.  Measures that could help achieve these goals include further reforms of the financial sector; increased government spending on infrastructure, environmental improvement, and the social safety net; and currency appreciation. 

I agree with your premise that it's important that the Chinese begin to appreciate further. 

Let me just raise a couple of issues which I guess I would call tactical issues, without addressing any specific legislative proposal.

The first is that the currency, while an important issue, is probably in itself not going to solve the trade imbalance problem. There are fundamental saving/investment imbalances, both in the United States and abroad, which need to be changed in order to make real progress on the trade balance.

And in particular we have emphasized with the Chinese the importance of structural changes in their economy, such as increased safety net and improved financial system, that would increase the share of their output going to consumers and being consumed at home. And the combination of currency appreciation and this other set of measures is really what's needed to begin to move things in the right direction.

So I would urge you to broaden your focus just a bit, beyond the currency, to talk about the savings and investment balances that need to be adjusted in both the United States and in China.

DODD: Is it still your opinion that {China's exchange rate} is an effective subsidy on that issue?

BERNANKE: It is not a subsidy in the legal sense, that is a subsidy is a payment by the government directly to producers to support their production. Nothing like that is going on. That's not what I was referring to.

I was talking about the economic implication, which is that the undervalued exchange rate creates a distortion in the economy which artificially sends resources into the export sector, as opposed to in the demand domestic sector.

So it is a distortion in the economy. From a legal perspective, it's not the same thing as...

DODD: No, I noticed where you said "effective" subsidy.

BERNANKE: Yes, or implicit.

Fixed, or partially fixed exchange rate regimes, of course, also constrain the independence of monetary policy. As capital accounts become progressively more open, few countries can sustain over time a commitment to exchange rate stability without risking price stability. Eventually central banks will run up against limits on their capacity to sterilize the effects of exchange market intervention designed to limit the pace and extent of appreciation of the exchange rate. Although measured inflation in emerging Asian economies remains relatively low, the pace of credit growth and the behavior of asset prices provide some evidence of a growing tension among competing objectives. The longer this policy conflict persists, the greater the distortions building up in the economy, the greater the risk of future inflation and the greater the risk of a bumpy future.

Fundamentally, the only realistic choice for policymakers is to equip their economies with the flexibility to cope more successfully in this increasingly integrated global economy. And this means preparing for a world of more rather than less flexibility in exchange rate regimes.