Rules for International Monetary Stability

Past, Present, and Future

Michael D. Bordo, John B. Taylor, Michael D. Bordo, John B. Taylor

• Publisher: Hoover Institution Press
• Year: 2017
• Print ISBN: 9780817920548
• eBook ISBN: 9780817920562
• Edition: 1
• Topic: Economics
• Subtopic: Finance
• Index: Economics

Since the end of the Great Recession in 2009 the central banks of the advanced countries have taken unprecedented actions to reflate and stimulate their economies. There have been significant differences in the timing and pace of these actions. These independent monetary policy actions have had significant spillover effects on the economies and monetary policy strategies of other advanced countries. In addition the monetary policy actions and interventions of the advanced countries have had a significant impact on the emerging market economies leading to the charge of 'currency wars.' The perceived negative consequences of spillovers from the actions of national central banks has led to calls for international monetary policy coordination. The arguments for coordination based on game theory are the same today as back in the 1980s, which led to accords which required that participant countries follow policies to improve global welfare at the expense of domestic fundamentals. This led to disastrous consequences. An alternative approach to the international spillovers of national monetary policy actions is to view them as deviations from rules based monetary policy. In this view a return to rules based monetary policy and a rolling back of the " global great deviation" by each country's central bank would lead to a beneficial policy outcome without the need for explicit policy coordination. In this book we report the results from a recent conference which brought together academics, market participants, and policy makers to focus on these issues. The consensus of much of the conference was on the need for a classic rules based reform of the international monetary system.

Chapter One

Monetary Policy Independence under Flexible Exchange Rates

The Federal Reserve and Monetary Policy in Latin America—Is There Policy “Spillover”?

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 markets’ volatility and capital mobility on the extent of monetary policy “spillovers.” 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 “taper tantrum.”1 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 “waiting game” 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, “[F]rom the perspective of emerging markets . . . it’s 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.”

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 countries—Chile, Colombia, Mexico, and Peru, for example—followed suit, and their respective central banks raised interest rates.2 In contrast, during that same short period most of the East Asian central banks remained “on hold.” An important question in this regard is, Why do some central banks “follow” 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 EMs’ 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, Agustín Casterns, the governor of the Bank of Mexico, publicly argued that the peso had weakened too much—it had “overshot”—and predicted that, eventually, it would go through a period of significant strengthening.3 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, “A 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.)”

At a policy level, an important issue is how emerging markets are likely to react when advanced countries’ central banks (and, in particular, the Federal Reserve) change their monetary policy stance.4 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 countries’ 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 don’t face the “trilemma.” 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.5 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 “spillover,” and could be the result of a number of factors, including the desire to protect domestic currencies from “excessive” depreciation.6 The late Ron McKinnon captured this idea when, in May 2014, he stated at a conference held at the Hoover Institution that “there’s only one country that’s truly independent and can set its monetary policy. That’s the United States.”7 Of course, not every comovement of policy rates should be labeled as “spillover.” It is possible that two countries (the United States and a particular EM, say, Colombia) are reacting to a common shock—a large change in the international price of oil, for example. “Spillover” would happen if, after controlling by those variables that usually enter into a central bank policy reaction function—the Taylor rule variables, say—there 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 countries—Chile, Colombia, and Mexico—to analyze the issue of policy “spillover” 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 countries’ 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 “spillover” 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 countries—often pooling countries as diverse as Argentina and India—or have based their simulations on a “representative EM.” (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 banks’ policy stance. (d) I explicitly investigate how changing conditions in the global economy—including the volatility of global financial markets—affect (if they do at all) the transmission process. (e) I investigate whether the degree of capital mobility affects the transmission process.8 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 ...

Table of contents

• Contents
• Preface
• Introduction
• 1. Monetary Policy Independence under Flexible Exchange Rates
• 2. The International Impact of the Fed When the United States Is a Banker to the World
• 3. A Journey Down the Slippery Slope to the European Crisis
• 4. The Fundamental Structure of the International Monetary System
• 5. Monetary Policy Cooperation and Coordination
• 6. Rules-Based International Monetary Reform
• 7. International Monetary Stability and Policy
• About the Contributors
• About the Hoover Institution’s Working Group on Economic Policy
• Index