On the implications of DCP for optimal monetary policy, see Egorov, Konstantin and Dmitry Mukhin, “Optimal Monetary Policy under Dollar Pricing,” March 2019. mimeo Yale University; and Casas, C, Diez, FJ, Gopinath, G and Gourinchas, PO (2017), ‘Dominant Currency Paradigm: A New Model for Small Open Economies’, IMF Working Papers 17/264. 27 For more detail, see ‘Lambda’, speech by Mark Carney, 16 January 2017. 26  10  All speeches are available online at www.bankofengland.co.uk/news/speeches  10  The growing risk of a global liquidity trap puts a high premium on getting more than just monetary policy right. Limited space for monetary policy to respond to adverse shocks means more of the burden for supporting jobs and activity will fall to fiscal policy. Though some may be tempted to resort to protectionism, such policies would merely serve to make the problem worse. Those at the core of the IMFS need to incorporate spillovers and spill backs, as the Fed has been doing. More broadly, central banks need to develop a better shared understanding of the scale of global risks and a recognition that concerted, cooperative action may sometimes be necessary. That doesn’t mean that monetary policy makers in advanced economies must internalise fully spillovers from their actions on emerging market economies, given their mandates are to achieve domestic objectives.
The amplification of spillovers by the IMFS matters less when the global expansions are relatively synchronised or when the US economy is relatively weak. But when US conditions warrant tighter policy there than elsewhere, the strains in the system become evident. These conditions emerged last year. US fiscal policy had boosted growth at a time when the US economy was near full employment. US monetary policy had to tighten consistent with the Fed’s dual mandate. The resulting dollar strength and financial spillovers tightened financial conditions in most other economies by more than was warranted by their domestic conditions (two thirds of the global economy was growing at below potential rates at the start of 2019, and that proportion has since risen to five sixths). More recently, the dramatic increase in trade tensions (Chart 1) has reinforced their effects by increasing risk premia. Today, the combination of heightened economic policy uncertainty (Chart 2), outright protectionism and concerns that further, negative shocks could not be adequately offset because of limited policy space is exacerbating the disinflationary bias in the global economy. What then must be done? In the short term, central bankers must play the cards they have been dealt as best they can. That means using the full flexibility in flexible inflation targeting. To retain the essential credibility of their frameworks, this is best done transparently with central bankers explaining their reasons for targeting specific trade-offs between price stability and output volatility.