Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy Independence

Abstract

There is a global financial cycle in capital flows, asset prices and in credit growth. This cycle co moves with the VIX, a measure of uncertainty and risk aversion of the markets. Asset markets in countries with more credit inflows are more sensitive to the global cycle. The global financial cycle is not aligned with countries' specific macroeconomic conditions. Symptoms can go from benign to large asset price bubbles and excess credit creation, which are among the best predictors of financial crises. A VAR analysis suggests that one of the determinants of the global financial cycle is monetary policy in the centre country, which affects leverage of global banks, capital flows and credit growth in the international financial system. Whenever capital is freely mobile, the global financial cycle constrains national monetary policies regardless of the exchange rate regime.

Financial Globalization and Bank Lending: The Limits of Domestic Monetary Policy?

“…Nevertheless, the missing efficiency of monetary policy with respect to lending dynamics is not surprising once recent findings of the international finance literature, which point to the potential interaction between domestic and foreign monetary policy, are taken into consideration. As suggested by Rey (2015), in the absence of capital controls, the monetary policy of the core economies may affect credit dynamics in non-central countries, which in turn points to limits of domestic monetary policy. Rey (2015) illustrates this relation by documenting the existence of global financial cycles which strongly negatively correlate with risk aversion and uncertainty typically approximated by the VIX index.…”

“…As suggested by Rey (2015), in the absence of capital controls, the monetary policy of the core economies may affect credit dynamics in non-central countries, which in turn points to limits of domestic monetary policy. Rey (2015) illustrates this relation by documenting the existence of global financial cycles which strongly negatively correlate with risk aversion and uncertainty typically approximated by the VIX index. Bruno and Shin (2015a), who document the cross-border effects of loose monetary policy in core economies, further develop this argument.…”

“…Based on country-level data, Bruno and Shin (2015b) show how US monetary policy spills over to cross-border bank capital flows through fluctuations in banks' risk-taking behavior, amplifying the leverage cycle in the foreign banking sector. On the aggregate level, Rey (2015) finds that the monetary policy of the US affects the leverage of global banks, which leads to co-movements of global asset prices and cross-border capital flows, and credit growth in the international financial system; this results in an "irreconcilable duo" -independent monetary policy is only possible if and only if the capital account is managed. Although our focus in this paper is not on banks' risk-taking behavior or financial stability, our findings imply that the existence of a global funding channel makes domestic monetary policy less effective, especially, for instance, when the central bank wants to tighten its monetary policy and put a brake on a domestic credit boom.…”

Divergent Emerging Market Economy Responses to Global and Domestic Monetary Policy Shocks

“…The response of policy rates-about a 5 basis point rise for the 1 percentage point hike in the US policy rate-is lukewarm and weaker than in other studies such as Frankel, Schmukler, and Servén (2004);andEdwards (2010, 2015). For example, Miranda-Agrippino and Rey (2015) explain 4% to 17% of the variation in the volatility index by shocks to the federal funds rate in a VAR analysis. 3 We do not take into account inflation pressures stemming from structural shifts (for example, perpetual shifts in productivity growth and demographics), ultimately altering real interest rates.…”

“…Capital flows into EMEs are an important transmission channel of global liquidity, as examined by Morgan (2011);Rey (2015); Broner et al (2013) ;Cerutti, Claessens, and Ratnovski (2014) ;Alberola, Erce, and Serena (2016); Kim and Shin (2016) ;Chari, Dilts-Stedman, and Lundblad (2017);and Cerutti, Claessens, and Rose (2017). We analyze four components of capital inflows: bond investments, equity investments, foreign direct investments, and other investments.…”