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 Discussion of Monetary Policy Contagion in the Pacific: A Historical Inquiry Sebastian Edwards Linda Tesar University of Michigan Federal Reserve Bank of San Francisco Asia Economic Policy Conference, November 19-­‐20, 2015 Objective of paper:
Estimate the impact of changes in US Federal Funds rate on monetary policy in six emerging markets as reflected in a standard specification of the Taylor rule. Latin America: Chile, Colombia, and Mexico Asia: Korea, Malaysia and the Philippines Weekly data: January 2000 -­‐ June 2008 -­‐ monetary policy regime: floating exchange rates with inflation targeting; reserve the right to intervene in foreign exchange market -­‐ …Managed float -­‐ Malaysia maintained peg to the USD during part of the sample -­‐ independent central banks -­‐ increased capital market integration 2 “Contagion” in monetary policy Estimate an error correction model that allows central banks to make adjustments at a gradual pace: !
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(5) ∆𝑟!! = 𝛼 + 𝛽𝐹𝐹! + 𝛾∆𝑟!!!
+ 𝛿𝑟!!!
+ 𝜃!,! 𝑥!,! + 𝜀! Regression includes contemporaneous variables plus lags. long-­‐term policy spillover = -­‐(β/δ) Does the Fed Funds rate have an independent effect even when other variables are held constant? covariates (a) Year over year inflation rate, lagged between four and six weeks. (b) Expected FX depreciation (difference between the three-­‐month forward exchange rate relative to the USD and the spot exchange rate) (c) Expected global inflationary pressures, (breakeven spread between the five-­‐ year Treasury and five-­‐year TIPS) 3 Results: Latin America -­‐ coefficient on Fed Funds rate is significantly positive -­‐ long-­‐term policy contagion is large. East Asia -­‐ coefficient on Fed Funds is significantly positive -­‐ long-­‐term policy contagion significant but smaller than for Latin America. Weak evidence that countries with more capital mobility (in Asia) have greater “pass-­‐through” of US inflation 4 “ Contagion “ in monetary policy “If, for whatever reason, a particular central bank feels that it needs to mimic (or follow) advanced countries, policy actions, then there will be policy “contagion” and the actual – as opposed to theoretical – degree of monetary policy autonomy will be greatly reduced.” This is a very strong statement. If an emerging market changes its interest rates along with the Fed, this is defined as a “contagious” spread of US policy and calls the EM’s monetary autonomy into question. Rests strongly on the assumption that the error correction model is picking up all of the things that could make the policy responses correlated even when the EM Central Bank is pursuing independent monetary policy objectives. 5 Are there reasons that interest rates might move in concert? i.e. EM is autonomous but shocks result in policy responses that are correlated: 1. Common real shocks (paper controls for a number of financial variables but does not have real variables at a high frequency) 2. Change in expectations about the future – e.g. downward revision about future global growth 3. News about future inflation or the exchange rate De Gregorio, Tolkman and Valdes (2005) “Flexible Exchange Rate with Inflation Targeting in Chile: Experience and Issues” “ First, monetary policy could be adjusted if the new information modifies the expected path of inflation. And second, news may trigger an intervention policy under exceptional circumstances, such as the adverse economic effects of an overreacting exchange rate.” 6 4. Transmission of real shocks from US to EM Canova “The Transmission of US Shocks to Latin America,” Journal of Applied Econometrics 2005. • Estimates VARs to identify shocks to US demand, supply and monetary policy • US monetary disturbances induce large and significant responses in several macroeconomic variables including output and inflation. The interest rate channel is a crucial amplifier of US monetary disturbances, while the trade channel plays a negligible role. • a contractionary US monetary shock induces a significant and instantaneous increase in Latin American interest rates which, in turn, are accompanied by capital inflows, price increases, depreciation of the real exchange rate and improvements in the trade balance. • Given that the majority of domestic fluctuations in the continent are of foreign origin, Latin American policymakers are required to carefully monitor international conditions and to disentangle the informational content of US disturbances in order to properly react to external imbalances … when the CB does this, is it contagion? 7 Misspecification of the Taylor rule? A good rule most of the time but not all of the time… Chang (2007) “Inflation Targeting, Reserves Accumulation, and Exchange Rate Management in Latin America” Latin American central bankers have often reserved and exercised the right to adjust interest rates to influence exchange rates, not only when the latter have signaled impending inflationary pressures, but also to curtail “excessive volatility” in the foreign exchange market and to “calm financial markets.” Colombia 1999: Banco de la Republica stated objective of its exchange rate policy: • The strategy of monetary policy has been implemented within a regime of flexible exchange rates, subject to intervention rules through which the following objectives have been sought: • To maintain an adequate level of international reserves that reduce the vulnerability of the economy to foreign shocks, both on current account and on capital account; • To limit excessive volatility of the exchange rate at short horizons, and • To moderate excessive appreciations or depreciations that endanger attaining future inflation targets and the financial and external stability of the economy. 8 Policy interest rates in industrialized countries with floating exchange rates 9 Explaining correlated rates: Policy “contagion” vs. endogenous policy response under the Taylor rule? “Austerity in the Aftermath of the Great Recession” Chris House, Christian Proebsting, and Linda Tesar multi-­‐country DSGE model that incorporates: -­‐ optimizing households and firms -­‐ government purchases -­‐ monetary policy rule – Taylor rule responds to domestic output and inflation -­‐ countries with both fixed and flexible exchange rates -­‐ trade in financial assets -­‐ price and wage rigidity -­‐ trade in intermediate inputs 10 Increase in ECB interest rate: -­‐ Results in increases in policy rates of floaters in the model; spillovers of ECB money shock to foreign GDP and inflation induces their CBs to raise policy rate. -­‐ Interest rate response is stronger the closer the trade and financial connections between the two countries 11 Summary -­‐ Paper does a nice job of documenting the connections between US and EM interest rates -­‐ “Contagion” result is provocative but not sure it is fully convincing -­‐ Need to control for all of the factors that could cause policy rates to co-­‐move -­‐ Should also explicitly control for episodes of intervention -­‐ Policy rates responded to other factors such as a desire to manage the exchange rate and to accumulate reserves -­‐ Possible to generate such policy rate co-­‐movements in a fairly general model 12