Chapter One
Monetary Policy Independence under Flexible Exchange Rates
The Federal Reserve and Monetary Policy in Latin AmericaâIs There Policy âSpilloverâ?
Sebastian Edwards
ABSTRACT
I use historical weekly data from 2000 to 2008 to analyze the way in which Federal Reserve policy actions have affected monetary policy in a group of Latin American countries: Chile, Colombia, and Mexico. I find some evidence of policy spillover during this period, in Chile and Colombia, but not in Mexico. In addition, I analyze whether changes in the slope of the yield curve in the United States have affected policy rates in these emerging markets (EMs). I also investigate the role of global financial marketsâ volatility and capital mobility on the extent of monetary policy âspillovers.â I provide some comparisons between these Latin American countries and a group of East Asian nations during the same period. The results reported here call into question the notion that under flexible exchange rates countries exercise a fully independent monetary policy.
1. Introduction
For central bankers from around the world, the years 2013 to 2015 were years of great apprehension as they waited for the Federal Reserve to make up its mind and to begin raising policy rates. As time passed without the Fed taking action, central bank governors became increasingly anxious. The first sign of apprehension came in June 2013 during the so-called âtaper tantrum.â Soon afterward, a number of influential central bankers from the periphery called for the Fed to normalize monetary policy once and for all. They wanted the âwaiting gameâ to be over and for the Fed to begin hiking interest rates. On August 30, 2015, the governor of the Reserve Bank of India, Ragu Rajan, told the Wall Street Journal, â[F]rom the perspective of emerging markets . . . itâs preferable to have a move early on and an advertised, slow move up rather than, you know, the Fed being forced to tighten more significantly down the line.â
The wait was finally over on December 17, 2015, when the Fed raised the federal funds policy target range by 25 basis points, from 0 to 0.25 to 0.25 to 0.50 percent. During the next few weeks many Latin American countriesâChile, Colombia, Mexico, and Peru, for exampleâfollowed suit, and their respective central banks raised interest rates. In contrast, during that same short period most of the East Asian central banks remained âon hold.â An important question in this regard is, Why do some central banks âfollowâ the Fed, while others act with what seems to be a greater degree of independence?
During the first few weeks of 2016, and as the world economy became more volatile and questions about China mounted, anxiety returned. In particular, many EMsâ central bankers became concerned about the rapid depreciation of their currencies, a phenomenon that they associated with the expectation that the Fed would continue to hike rates during 2016. For example, in an interview published in the Financial Times, AgustĂn Casterns, the governor of the Bank of Mexico, publicly argued that the peso had weakened too muchâit had âovershotââand predicted that, eventually, it would go through a period of significant strengthening. During February 2016, the degree of apprehension among periphery central bankers increased when the Bank of Japan moved its policy rate to negative terrain. In part as a result of this action, long rates declined, and the yield curve became flatter. On February 10, 2016, the Wall Street Journal said, âA little more than a month after the Federal Reserve lifted its benchmark rate from near zero, rates across the market are falling. The yield on the 10-year US Treasury note, a benchmark for everything from corporate rates to corporate lending this week fell below 1.7%, its lowest level in a year. (Emphasis added.)â
At a policy level, an important issue is how emerging markets are likely to react when advanced countriesâ central banks (and, in particular, the Federal Reserve) change their monetary policy stance. According to received models of international macroeconomics (i.e., the Mundell-Fleming model, in any of its versions), the answer to this question depends on the exchange rate regime. Countries with pegged exchange rates cannot pursue independent monetary policy, and any change in the advanced countriesâ central bank policy rates will be transmitted into domestic rates (with the proper risk adjustment). However, under flexible exchange rates countries are able to undertake independent monetary policies and donât face the âtrilemma.â In principle, their central bank actions would not have to follow (or even take into account) the policy position of the advanced nations, such as the United States. More recently, however, some authors, including, in particular, Taylor (2007, 2013, 2015) and Edwards (2012, 2015), have argued that even under flexible exchange rates there is significant policy interconnectedness across countries. In a highly globalized setting, even when there are no obvious domestic reasons for raising interest rates, some central banks will follow the Fed. This phenomenon may be called policy âspillover,â and could be the result of a number of factors, including the desire to protect domestic currencies from âexcessiveâ depreciation. The late Ron McKinnon captured this idea when, in May 2014, he stated at a conference held at the Hoover Institution that âthereâs only one country thatâs truly independent and can set its monetary policy. Thatâs the United States.â Of course, not every comovement of policy rates should be labeled as âspillover.â It is possible that two countries (the United States and a particular EM, say, Colombia) are reacting to a common shockâa large change in the international price of oil, for example. âSpilloverâ would happen if, after controlling by those variables that usually enter into a central bank policy reaction functionâthe Taylor rule variables, sayâthere is still evidence that the EM in question has followed the Fed.
The purpose of this paper is to use data from three Latin American countriesâChile, Colombia, and Mexicoâto analyze the issue of policy âspilloverâ from a historical perspective. More specifically, I am interested in answering the following questions: (a) Have changes in the Fed policy rate historically affected the policy stance of these countriesâ central banks, even after controlling for other variables? (b) If the answer is yes, how strong has the policy pass-through been? (c) What is the role played by the yield curve in the policy âspilloverâ process? Does it make a difference if the policy rate hike is accompanied by a flattening or steepening of the global yield curve? (d) What has been the role of global instability in the transmission mechanism of policy interest rates? and (e) Has this process been affected by the degree of capital mobility in the specific countries? In order to put my findings in perspective, in the final section of the paper, I compare the results obtained for the three countries in the sample to a group of East Asian nations. Although the analysis presented here is based on historical data (2000 to 2008), the answers are particularly pertinent for the current times, as an increasing number of central banks in the emerging nations are considering the issue of whether to react to Fed policy moves.
This paper differs from previous work on the subject in several respects: (a) I concentrate on individual countries. This allows me to detect differences across nations. Most analyses of related subjects have relied on either pooled (panel) data for a group of countriesâoften pooling countries as diverse as Argentina and Indiaâor have based their simulations on a ârepresentative EM.â (b) I use short-term (weekly) time series data. As a consequence, I am able to follow the granularity of the transmission from interest rates in the United States to interest rates in the EMs of interest. (c) As noted, I focus on the important issue of the slope of the yield curve, and I analyze how changes in the policy rate and the long rate have interacted to affect the three central banksâ policy stance. (d) I explicitly investigate how changing conditions in the global economyâincluding the volatility of global financial marketsâaffect (if they do at all) the transmission process. (e) I investigate whether the degree of capital mobility affects the transmission process. And (f) I provide an explicit comparison between a group of Latin American countries and a group of Asian nations.
2. Preliminaries
Before moving forward, a note ...