Will central banks around the world follow the U.S. Federal Reserve when it finally decides to raise its benchmark federal funds rate?
Two economists at the Bank for International Settlements (BIS) posed the highly topical question in its September quarterly review and concluded there are significant global spillovers from U.S. monetary policy, both when the Fed raises rates and when it cuts rates.
However, the authors of an article in the latest edition of the highly-respected review caution against simplistic conclusions, saying non-U.S. policymakers may in fact tolerate a deprecation of their currencies’ exchange rates or short-term capital outflows when the Fed tightens, rather than exchange rate appreciations and capital inflows.
“Hence, while our results provide evidence of past spillovers, one should be cautious in applying them to predict potential future spillovers,” writes Boris Hofmann and Elod Takats, senior economists at Swiss-based BIS, known as the central bankers’ bank.
In the article, “International monetary spillovers,” Hofmann and Takats explore the recent correlation of interest rates in the United States with that in emerging market economies and smaller advanced economies even though business cycles have been at different stages.
Unlike other studies, they focus on 22 emerging market economies and eight advanced economies that are well integrated into the global financial system and on the post-2000 period – a choice that is important because global financial and economic integration is a key driver in monetary spillovers.
While several earlier studies have found a significant impact of U.S. rates on long-term interest rates in other countries, Hofmann and Takats also find evidence of spillovers from U.S. monetary policy on short-term and policy rates beyond what business cycles or risk factors would justify.
In addition, they also find that interest rates in the U.S. affect interest rates in other countries under both fixed and floating exchange rate regimes.
This supports a thesis by Helene Rey, who at the 2013 Jackson Hole conference presented a paper about the global financial cycle that is mainly determined by U.S. monetary policy.
Hofmann and Takats suggest that the spillover from U.S. monetary policy to other economies works through two channels.
The first channel is via investor behavior. As investors search for yield, they shift funds from low-yielding bonds in core economies to higher-yielding bonds elsewhere, pushing down those yields.
The second channel works when central banks in emerging markets and smaller advanced economies follow the U.S. to prevent the emergence of large interest rate differentials in an effort to avoid exchange rate appreciation that could result in a loss of trade competitiveness.
Alternatively, emerging market central banks may also be concerned that large interest rate differentials could induce speculative short-term capital inflows that could lead to financial instability.
“This would tie their policy rates to US policy rates, and, if market expectations then projected this linkage through the rest of the yield curve, other short- and long-term interest rates would follow,” the two authors write.
Please click here to read the BIS September quarterly review.