The Paradox of Central-Bank Cooperation

While the Fed’s recent decision to continue its purchases of long-term assets – so-called quantitative easing – was motivated largely by domestic economic uncertainty, the prospect of interest-rate spikes in emerging economies added significant pressure. But should central banks account for monetary policy’s spillover effects?

PRINCETON – The US Federal Reserve’s recent surprise announcement that it would maintain the current pace of its monetary stimulus reflects the ongoing debate about the desirability of cooperation among central banks. While the Fed’s decision to continue its massive purchases of long-term assets (so-called quantitative easing) was motivated largely by domestic economic uncertainty, fears that an exit would trigger interest-rate spikes in emerging economies – especially Brazil, India, Indonesia, South Africa, and Turkey – added significant pressure. But should central banks’ decision-making account for monetary policy’s spillover effects?

Discussion of central-bank cooperation has often centered on a single historical case, in which cooperation initially seemed promising, but turned out to be catastrophic. Like most of our modern cautionary tales, it comes from the Great Depression.

In the latter half of the 1920’s, there was almost constant transatlantic tension, as US monetary policy drove up borrowing costs and weakened GDP growth in Europe. In 1927, at a secret meeting on New York’s Long Island, Europe’s leading central banks convinced the Fed to cut its discount rate. Although the move helped to stabilize European credit conditions in the short term, it also fueled the speculative bubble that would collapse in 1929.

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