The illusion of monetary policy independence under flexible exchange rates

Sebastian Edwards

The conventional ‘trilemma’ view is that countries that allow free capital flows can still pursue independent monetary policies as long as they allow flexible exchange rates. This column examines the pass-through of Federal Reserve interest rates to policy rates in Chile, Colombia, and Mexico. The author concludes that, to the extent that central banks take into account other central banks’ policies, there will be ‘policy contagion’ and that, even under flexible rates, monetary policy will not be fully independent.

Throughout his long and distinguished career, Ronald I. McKinnon embarked on many crusades. Perhaps his best-known concern was related to the need to end ‘financial repression’ and liberalise the financial sector in developing countries (McKinnon 1973). In the last 25 years the policy issue that occupied most of McKinnon’s time had to do with exchange rate regimes. Ron McKinnon was, decisively, a fixed exchange rates economist. He advocated a system that he defined as “a gold standard without gold” (McKinnon 1987; see also McKinnon 1993).

In a recent paper, presented at a conference in Ron McKinnon’s memory, I investigate whether, as suggested by traditional theory (the Mundell–Fleming model), countries with flexible exchange rates have historically been able to pursue a truly independent monetary policy (Edwards 2015). I argue that, to the extent that central banks take into account other central banks’ policies, there will be ‘policy contagion’ and that, even under flexible rates, monetary policy will not be fully independent.

I use data from three Latin American countries with flexible exchange rates – Chile, Colombia, and Mexico – to analyse the extent to which policy changes by the Federal Reserve are transmitted into domestic policy interest rates. I cover the period from January 2000 through early June 2008. That is, I exclude the turmoil that followed the collapse of Lehman Brothers and the Fed policy based on zero interest rates and quantitative easing.1

This analysis is particularly relevant at the time of this writing (early 2015), as the Federal Reserve is expected to begin hiking policy interest rates in mid- to late-2015. A key question at this juncture is this: What is the historical evidence regarding the impact of Fed interest rate hikes on Latin American policy interest rates and financial markets? Will these countries be able to maintain monetary independence when the Federal Reserve enters a tightening cycle, or will they tend to follow the Fed?

Policy independence or policy contagion?

In a country with a credible fixed exchange rate and free capital mobility, local interest rates (in domestic currency) will not deviate from foreign interest rates. Under these circumstances, changes in world interest rates will be transmitted in a one-to-one fashion to the local economy. It is in this sense that with (credible) pegged exchange rates there cannot be an independent monetary policy; the local central bank cannot choose its own rate of interest.

Under flexible rates, however, it is possible for domestic interest rates to deviate from world rates. In this case the exchange rate will be the ‘shock absorber’. However, as Dornbusch (1976) showed in a classic paper, the exchange rate will tend to ‘overshoot’ and be highly volatile.2

If central banks want to avoid ‘excessive’ exchange rate volatility, they are likely to take into account other central banks’ actions when determining their own policy rates. That is, it is possible that the policy rule (i.e. the Taylor Rule) will include a term with other central banks’ policy rates – see Edwards (2015) for details.3 Whether this is indeed the case, and central banks tend to ‘import’ other central banks’ policies, is an empirical issue.

A preliminary look at the data

Chile, Colombia, and Mexico are the three Latin American countries with available weekly data for the variables of interest. In addition, they have three important characteristics in common: they followed inflation targeting during the period under study, they had a relatively high degree of capital mobility, and had independent central banks. In that sense, they constitute a somewhat homogenous group.

In Figure 1 I present data on these three countries’ central banks’ policy rates and on the Federal Reserve’s Federal Funds rate. During this period there were 40 changes in the Federal Funds rate. Twenty corresponded to rate increases, and 20 to rate cuts. Simple inspection of Figure 1 suggests that there was some relation between the Fed Funds target rate and policy interest rates in the Latin American sample. This is particularly so during the earlier period. The relation, however, is far from perfect.

Figure 1. Monetary policy rates in the US, Chile, Colombia, and Mexico: 2000-08

A ‘contagion’ empirical model of monetary policy

In Edwards (2015) I estimate a number of equations for monetary policy rates for Chile, Colombia, and Mexico. These equations are of the ‘error correction’ type, and provide estimates of the dynamic effect of these policies through time, and allow investigation of whether these countries’ central banks were indeed subject to policy contagion. If in the estimation the long run ‘pass-through’ coefficient is equal to one there will be full contagion; if, on the contrary, this coefficient is zero, there will be policy independence.

In the estimation the dependent variable is the change in each country’s policy rate. I included the following covariates: lagged year-over-year inflation rate, lagged expected depreciation, and a measure of expected global inflationary pressures, with one period lag.4 In addition, in some regressions I included an indicator of country risk premium, defined as the lagged EMBI spread for Latin America.

The results are quite satisfactory – see Edwards (2015) for details. This is especially the case considering that interest rate equations are often difficult to estimate. Most coefficients are significant at conventional levels, and have the expected signs. The most salient findings may be summarised as follows:

The coefficient of the Federal Funds rate (FF-Policy) is always significantly positive, indicating that during the period under study there was, indeed, ‘policy contagion’ from the US policy rates into central banks’ policy interest rates in the three Latin American countries in the sample.

The extent of long-term policy contagion is rather large. The point estimates for the long run ‘pass-through’ coefficient range from 0.32 for Mexico to 0.74 for Colombia; for Chile it is between 0.45 and 0.74. However, in none of the three cases is the pass-through one-to-one.

These results also indicate that inflationary pressures – both domestic and global – result in higher policy rates. The same is true for expected devaluation and higher country risk premia.

As an extension, in a number of regressions I added the change of the country’s main commodity export as a proxy for real activity. The results regarding ‘policy contagion’ are maintained. In addition, I show that when commodity prices go cumulatively up, central banks tend to hike interest rates.

I also estimated regressions with other lag structures – and with no lags at all. In addition, in some of the estimates I used instrumental variables to take into account the possible endogeneity of the expected rate of devaluation. These estimates show that the basic results were maintained and are robust to the estimation technique.

An important question is whether the degree of capital mobility affects the extent of interest rate pass-through. In order to address this issue I added an index of capital mobility to the regression analysis. The results obtained confirm the findings reported above; in addition, there is no evidence suggesting that the extent of the pass-through depends on the degree of capital mobility.

Concluding remarks

At the time of this writing – early 2015 – it is expected that the Federal Reserve will raise interest rates before the end of the year. It will be the first Federal Funds hike since 2006. How is this tightening going to affect emerging markets? In Edwards (2015) I provide a (partial) answer to this question by investigating the extent to which Fed policy actions have, in the past, been passed into monetary policy interest rates in three Latin American nations with flexible exchange rates – Chile, Colombia, and Mexico.

The basic estimates suggest that Federal Reserve interest rate changes are imported, on average, by 74% in Colombia, more than 50% in Chile, and 33% in Mexico. That is, if the Federal Reserve were to hike rates by a cumulative total of 325 basis points – bringing the Fed Funds rate to 3.5% – we could expect that (with other things given) Colombia would hike policy rates by 250 basis points, Chile by almost 175 basis points, and Mexico by more than 100 basis points.

A possible explanation for the results reported in this paper is ‘fear of floating’, or the concern that sharp changes in currency values may generate major dislocations in domestic economies. One way of reducing the risk of exchange rate fluctuations is for local central banks to maintain interest rates within certain ranges.5

The results reported in this column call into question the idea that under flexible exchange rates there is monetary policy independence. Whether there is policy contagion in other countries, besides the ones included in this study, is an open question whose answer will require additional empirical research.

References

Aizenman, J, M Binici, and M M Hutchison (2014), “The Transmission of Federal Reserve Tapering News to Emerging Financial Markets”, NBER Working Paper 19980.

Calvo, G A and C M Reinhart (2000), “Fear of Floating”, NBER Working Paper 7993.

Dornbusch, R (1976), “Expectations and exchange rate dynamics”, Journal of Political Economy 84(6): 1161–1176.

Edwards, S (2006), “The Relationship Between Exchange Rates and Inflation Targeting Revisited”, NBER Working Paper 12163.

Edwards, S (2012), “The Federal Reserve, the Emerging Markets, and Capital Controls: A High‐Frequency Empirical Investigation”, Journal of Money, Credit and Banking 44(s2): 151–184.

Edwards, S and E Levy Yeyati (2005), “Flexible exchange rates as shock absorbers”, European Economic Review 49(8): 2079–2105.

Edwards, S (2015), “Monetary Policy Independence under Flexible Exchange Rates: An Illusion?”, NBER Working Paper 20893.

McKinnon, R I (1987), “A gold standard without gold. Putting a stop to rapid currency swings”, The New York Times, 12 April.

McKinnon, R I (1993), The order of economic liberalization: Financial control in the transition to a market economy, Johns Hopkins University Press.

Taylor, J B (2007), “Globalization and monetary policy: Missions impossible”, in J Galí and M Gertler (eds.), International Dimensions of Monetary Policy, University of Chicago Press: 609–624.

Taylor, J B (2013), “International monetary coordination and the great deviation”, Journal of Policy Modeling 35(3): 463–472.

Footnotes

1 Aizenman et al. (2014) analysed how the announcement of Federal Reserve tapering in 2013 affected financial conditions in emerging markets.

2 The shock absorber role of the exchange rate goes beyond monetary disturbances. Edwards and Levy-Yeyati (2005) show that countries with more flexible rates are better able to accommodate terms of trade shocks.

3 In Edwards (2006) I argue that many countries include the exchange rate as part of their policy (or Taylor) rule. Taylor (2007, 2013) has argued that many central banks include other central banks’ policy rates in their rules. The analysis that follows in the rest of this section owes much to Taylor’s insights.

4 However, it is possible to argue that once the Fed Funds rate is included, the coefficient of the spread between Treasuries and TIPS should be zero, since the Fed Funds rate already incorporates market expectations of US inflation.

5 Calvo and Reinhart (2000) is the classical reference on this subject.