The IMF has published an interesting paper on global liquidity effects and their impact on eurozone monetary policy. The authors found that excess U.S. liquidity is a primary determinant of excess liquidity and inflation in the eurozone:
Global excess liquidity is sometimes believed to limit sovereign monetary policy even in large economies, including the euro area. There is much discussion about what constitutes global excess liquidity and our approach adjusts liquidity for longer-term interest rate and output effects. We find that especially excess liquidity in the U.S. leads developments in euro area liquidity. U.S. excess liquidity also enters consistently positive as a determinant of euro area inflation. There is some evidence that this result may be related to a weakening of the effectiveness of monetary policy in the euro area during times of excessive U.S. liquidity.
This observation should inform the common sense of monetary policy; that the actions of the supplier of the world’s reserve currency impact global monetary conditions is hardly a new or radical idea. But it does provide additional support to the idea that the U.S. has been a pretty lousy global monetary steward since it assumed that role around WWI. And it argues, in our view, against the overwhelming consensus that monetary policy is the most appropriate policy lever for supporting the U.S. economy. If this were the 1930s or 1940s, such an approach might work. But in an integrated global economy, the issuer of the primary reserve currency needs to manage policy based on global, not domestic, economic conditions. As Robert Mundell has argued, the Federal Reserve, which was formed in 1913, was the ‘new kid on the block’ in the interwar period, and it struggled to provide the caliber of monetary leadership that the Bank of England had provided in the 19th century. Unfortunately, that hasn’t changed much. The Fed has yet to accept its global leadership role, remaining mired in an inwardly focused framework that is a legacy of the Great Depression, prevailing theory, and misguided Congressional mandates.