Every year, the Kansas City Federal Reserve hosts its Jackson Hole Economic Policy Symposium for the World’s Central Bankers and other international economic policy-influencers. At the event in Jackson Hole, Wyoming, the risky economic environment created by volatile U.S. trade policy and active central bank responses were among the issues looming over the minds of the high-profile attendees.
Professor Sebnem Kalemli-Ozcan informed attendees’ discussions by presenting her research on how U.S. Federal Reserve policy can spill over into other economies by increasing the perceived risk of investing in those countries – particularly in emerging markets economies (EMEs). She argued that responding to U.S. policy with an active interest rate policy could be counterproductive for those countries because of increased borrowing costs for their consumers and businesses. She proposed that they instead rely on floating exchange rates. Observers of the conference deemed her work crucial to understanding the key themes of the meeting, as it received extensive coverage in Reuters, The Financial Times, The Economist, and Bloomberg.
Her argument has a twist to the following conventional wisdom. When the U.S. raises interest rates, the difference between interest rates in other countries and the U.S. decreases, and in response global investors shift assets towards the U.S., with its higher interest rate. However, a driver of countries’ interest rate gaps---monetary policy divergence---with the U.S. is the sensitivity of capital flows to the perceived risk in their economies. This risk is affected by U.S. monetary policy and by the countries’ own monetary policy responses.
Kalemli-Ozcan shows that in comparison to advanced economies, emerging market economies have larger-on-average and more varying interest rate differences with the U.S. Moreover, how these differentials affect capital flows through the countries depends on investors’ perception of risk. U.S. policy can introduce risks that all economies face, and these risks are amplified by the local risk of a given economy, which is higher in emerging economies.
Consistent with this line of reasoning, she documents that in response to an increase in the U.S. policy rate, the interest rates in advanced economies also rise, but not as much as the U.S. rate – which decreases the difference between rates of those economies and the U.S. rate. In contrast, EMEs respond with a rate increase that is larger than the change in the U.S., which increases the differences in interest rates.
To understand the implications of this for consumers and firms, it is important to note that EMEs rely heavily on domestic banks for facilitating capital flows. So when the U.S. raises its interest rate, it creates an incentive for capital to flow out of the EMEs and into the U.S. When the EMEs raise their interest rates in response, the cost of borrowing in those economies increases and banks provide less credit. Kalemli-Ozcan shows that domestic monetary policy is effective in responding to capital outflows in advanced economies, but not in EMEs. This means that there are costly spillovers from U.S. monetary policy in EMEs.
Given the costs of EMEs responding to U.S. policy with interest rate policy, the main alternative she presents is floating exchange rates. She documents that output growth of countries with pure floats relative to managed floats is more insulated from U.S. policy. She also stresses the importance of improving institutional quality (property rights, corruption, government stability and efficiency, rule-of-law, central bank independence) in EMEs as an important channel for decreasing the country-specific risk and the resulting sensitivity to capital flows to shifts in U.S. monetary policy.