“Global Spillovers and Domestic Monetary Policy”

If QE1 through QE3 and other unconventional monetary policy (UMP) measures had little impact upon implementation, why did the hint of a stepback induce such large reactions in international markets?


Figure from Wigglesworth, Wagstyl, “Quantitative easing: End of the line,” FT, June 23, 2013..

I doubt that there will be a persuasive answer to that question from those who doubted the efficacy of UMP in the past, but in this paper presented at the BIS Annual Conference, entitled “Navigating the Great Recession: what role for monetary policy?”, I argue that various unconventional monetary measures did in fact have substantial spillover effects from the advanced economies to the emerging market economies, and attempt to interpret those effects in the context of various models. From the paper:

In general, quantitative and credit easing and forward guidance seem to weaken the home currency, at least in some instances. This means that countries not matching expansionary monetary policy in the advanced economies will occasionally see their currencies face upward pressure. Policymakers in these countries will then have to decide whether to offset the upward pressure with increased foreign intervention, lower interest rates, or capital controls.
The consequent policy challenge will vary depending on the situation facing individual countries. Countries already at or near full employment might welcome the resulting appreciation of their currency, as long as they were near external balance. However, for those countries that are far below full employment, such an occurrence will be very unwelcome. (And of course, even countries near full employment might not welcome currency appreciation for reasons of political economy).
In other words, global rebalancing remains important. If the economies facing considerable economic slack (mostly the advanced economies, Figure 14) were to undertake monetary easing as a group, while the emerging market economies (near full employment, Figures 14 and 15) were to allow currency appreciation, this might actually yield a positive outcome.
In the medium to long run, the impact is ambiguous. That is partly because the transmission mechanism involved differs from that related to foreign exchange intervention (at least as far as credit easing goes). To the extent that credit easing lowers interest rates facing firms and households, or loosens credit constraints, domestic absorption is raised. This in turn will lead to greater economic activity and hence self-reinforcing growth, as opposed to expenditure switching. Obviously, had foreign exchange intervention been pursued, the boost to economic activity would have more likely come from the respective export sectors.
However, the implications for impacted countries will take on a different complexion depending upon the channel by which exchange rate depreciation is effected. For instance, if the primary effect is through a signaling effect regarding the conduct of future monetary policy – for instance a commitment to low interest rates into the future – then a depreciated exchange rate has straightforward impact, switching expenditures toward the country implementing the policy.
If however the currency depreciation is accompanied by other effects related to portfolio balance motivations, then the implications will vary by country. For instance, if credit easing works through increasing demand (or equivalently reducing net supply) for U.S. long term Treasurys, then other assets that have returns that are correlated with U.S. long term Treasurys will also likely react similarly. For instance, as shown in Gagnon et al. (2010), yields on long term securities for the advanced economies all declined when LSAPs were announced.
This suggests a differential impact for advanced economies versus emerging market economies. Long term yields for sovereign bonds are all likely to decline in response to purchases of US long term Treasurys, as they are relatively substitutable. On the other hand, sovereign debt of emerging markets will likely exhibit a more muted effect, and the dollar’s decline against those currencies will likely be measurably greater (Although Fratzscher et al.’s results suggests there are no assurances.)
One perspective on the ongoing program of monetary expansion by way of unconventional means holds that these measures threaten the stability of the global economy. Another perspective – the right one in my view – takes the reflationary measures in the advanced economies as a welcome development.
The international dimension of the anxieties is centered, I believe, on the fact that advanced economy measures force a choice upon emerging markets: to accept capital inflows (perhaps offsetting domestic effects by sterilization), to stem those inflows by way of capital controls, by allowing currency appreciation, or a combination of these measures. The (understandable) fear is that such capital inflows will spark a credit boom-bust cycle. The choices are most stark for small open economies.
However, the benefits of expansionary monetary policy outweighs the costs. If the advanced economies undertake expansionary policies that tend to weaken their respective currencies, then one is tempted to say that this is a wash, with no advantage conferred to a given country. Yet, if the unconventional measures raise the inflation rate, thereby reducing real interest rates, and spur domestic economic activity, both the advanced economies and the emerging market economies benefit.
It is true that some countries might face upward pressure on currency values; if they resist by way for foreign exchange intervention (as in China’s case in the past), they will be forced to engage in ever more extensive sterilization procedures, or imposition of capital controls. The evidence of the efficacy of the latter, in the face of recent capital inflows from the advanced economies arising from large scale asset purchase, is quite limited (Fratzscher, et al., 2012).

The conference included contributions from Philippe Aghion (Harvard), Athanasios Orphanides (MIT) and John Taylor (Stanford). While the other papers are not yet publically available on the BIS website, you can see Steve Cecchetti’s (BIS) opening remarks here and John Taylor’s paper here.


This conference is different from the BIS Annual General Meeting, which took place a couple days afterward. The presentations at that meeting are available here. Paul Krugman has his take on the general message in the Annual Report released at the meeting here.

9 thoughts on ““Global Spillovers and Domestic Monetary Policy”

  1. Edward Lambert

    “Yet, if the unconventional measures raise the inflation rate, thereby reducing real interest rates, and spur domestic economic activity, both the advanced economies and the emerging market economies benefit.”
    There is the rub. The bottleneck is low labor income, which constrains demand and inflation. No solution for that yet in sight, so benefits are not realized.
    I now reason that the only way to save the economies of the West is to raise wages and raise interest rates. It is clear that wages have to rise, but if capital stays cheap, labor is put at a disadvantage. Thus, if we raise wages, which we must, interest rates must rise too. The result will be to raise efficiency of “social costs”, which are accumulating from long-term low rates and low labor income. Social costs are weighing down on aggregate demand. They need to be cleaned out like China is now cleaning out its inefficient investments by raising interest rates.
    To raise rates and wages, we would experience a hit to demand that would be temporary, then demand would rise back to healthy levels. This path is preferable to a permanent suppression of demand from cheap labor in the face of cheap capital.

  2. tj

    If QE1 through QE3 and other unconventional monetary policy (UMP) measures had little impact upon implementation, why did the hint of a stepback induce such large reactions in international markets?
    Perhaps the intuition of the ‘man on the street’ that QE was inflating interest sensitive asset prices, like government debt, equities, real estate, etc, was more accurate than whatever theoretical measure you were using to conclude that UMP ‘had little impact’.

  3. Menzie Chinn

    tj: I believe you misapprehend my comment — the question was rhetorical. I believed QE1 through QE3 had impacts; it was the critics of the policies that often questioned the efficacy of these measures.

  4. W.C. Varones

    I don’t know anyone who doubted the efficacy of UMP to create asset bubbles.
    What we doubted was the ability of money-printing to create a self-sustaining recovery in the real economy.
    The recent market turmoil and the past four years’ sluggish recovery do nothing to contradict that view.

  5. don

    I am puzzled by the so-called credit crunch in China. It does not seem reasonable to attribute it to Ben’s hints of reductions in QE.
    QE may have had an effect on housing, and perhaps on consumption through the effect on asset prices, but it also operated through the effect on exchange rates and international trade. China’s currency policy seems to have insulated it, at least partly, from the trade effect, but other countries felt the brunt. It seems unlikely to me that the net effect of QE was positive on other economies that did not peg their exchange rate – that is, I would have expected the effect of QE on domestic U.S. demand to be more than offset by the adverse trade effect on trading partners. The exception would be China and economies that supply China with raw materials or intermediate inputs.

  6. Chicken

    Doing a bang up job of keeping Mom and Pop on the sidelines and allowing those on the inside to front-run anything and everything, with free capital.

  7. ivars

    These measures popped up financial bubbles from stocks to bonds to housing and now if QE is taken away they are naturally bursting.

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