Global Financial Conditions and Monetary Policy Autonomy

Abstract

Is the Mundell-Fleming trilemma alive and well? International co-movement of asset prices takes place alongside synchronized business cycles, complicating the identification of financial spillovers and assessments of monetary policy autonomy. A benchmark for interest rate comovement is to impose the null hypothesis that central banks respond only to the outlook for domestic inflation and output. We show that common approaches used to estimate interest rate spillovers tend to understate the degree of monetary autonomy enjoyed by small open economies with flexible exchange rates. We propose an empirical strategy that partials out those spillovers that are associated with impaired monetary autonomy. Using this approach, we revisit the predictions of the trilemma and find more compelling evidence that flexible exchange rates deliver monetary autonomy than prior work has suggested.

International spillovers in global asset markets

“…A number of studies is dedicated to monetary policy spillovers (e.g. Caceres, Carriere-Swallow and Grus, 2016) as well as interactions between monetary policy and financial markets (e.g. Rigobon and Sack, 2003).…”

U.S. Monetary Policy Normalization and Global Interest Rates

“…The estimation of autonomy-impairing spillovers from U.S. interest rates follows the twostage VAR approach in Caceres, Carrière-Swallow, and Gruss (2016). In the first stage we estimate a country-specific VAR(p) model including domestic variables only:…”

“…Caceres, Carrière-Swallow, and Gruss (2016) argue that inference about monetary autonomy based on spillover estimates can be biased when economic cycles are synchronized, possibly affecting conclusions about the role of exchange rate flexibility and other factors as determinants of autonomy. They estimate spillovers while modeling the domestic monetary policy reaction function for a panel of advanced and emerging economies, splitting the sample into countries with flexible exchange rates and countries with pegs or soft pegs.…”

“…What policies can help monetary authorities regain more autonomy vis-à-vis global financial shocks? Caceres, Carrière-Swallow, and Gruss (2016) argue that inference about monetary autonomy based on estimates of interest rate spillovers can lead us to overstate the limits to monetary autonomy when business cycles are correlated across countries. The starting point of their analysis is the idea that countries facing similar shocks should be expected to respond with similar monetary policies, even if these are completely inward-looking.…”

“…We find that a majority of countries in our sample have managed to tailor their monetary stance to domestic 2 The debate on the ability of open economies to implement autonomous monetary policies in the context of a highly integrated global financial system has intensified recently. See, for instance, Rey (2015), Obstfeld (2015), and Caceres, Carrière-Swallow, and Gruss (2016). conditions. However, in some cases, monetary conditions did tend to deviate from domestic objectives following movements in U.S. interest rates.…”