Working Paper: CEPR ID: DP17748
Authors: Pierre De Leo; Gita Gopinath; Sebnem Kalemli-Ozcan
Abstract: We document that emerging market central banks adhere to Taylor-type rules and lower their policy rates when economic activity slows down, including as a response to U.S. monetary policy tightening. This suggests a countercyclical monetary policy stance. However, in contrast to advanced economies, short-term market rates do not move in tandem with policy rates. Market rates, if anything, tend to increase during recessions. We present evidence that this disconnect between policy rates and market rates can be significantly explained by fluctuations in dollar funding premia that get transmitted into local market rates through the banking sector that relies on foreign funding. Our findings shed light on the challenges to transmission and effectiveness of monetary policy in emerging economies.
Keywords: Monetary Policy; Emerging Market Economies; US Monetary Policy Shocks
JEL Codes: E43; E50; E52; F30
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Emerging economies' central banks lower their policy rates (E52) | Deteriorating local economic activity (R11) |
| Exogenous U.S. monetary policy tightening (E49) | Emerging market central banks cut their policy rates (E52) |
| Emerging market central banks cut their policy rates (E52) | Short-term market rates tend to increase (E43) |
| Short-term market rates tend to increase (E43) | Contractionary force on economic activity (E49) |
| Reliance on global funding markets (F65) | Incomplete passthrough of monetary policy to short-term rates (E49) |
| External shocks (F69) | Local monetary policy dynamics (E19) |