Is financial globalization making monetary policy less effective?

The strengthening of cross-border financial integration since the 1990s has triggered a heated debate as to whether financial globalisation has weakened monetary policy effectiveness. Until the Global Crisis of 2007-2009, the consensus was that financial globalisation had not materially reduced monetary policy control (Yellen 2006, Bernanke 2007, Woodford 2007).

But the debate has intensified since the Global Crisis. Evidence that domestic financial conditions are increasingly determined by developments in the rest of the world has attracted growing attention. For example, it has been argued that financial conditions in the world’s foremost financial centre, the US, spill over to other economies through global financial cycles, and override the efforts of local monetary policy to steer domestic financial conditions (Shin 2012, Rey 2013, Bruno and Shin 2015, Obstfeld 2015, Passari and Rey 2015). Put differently, due to global financial cycles, non-US central banks allegedly lose the ability to control domestic long-term interest rates, which are central in monetary policy transmission.

This debate has been particularly heated in emerging market economies, but it also concerns advanced economies. For instance, when explaining the ECB’s decision to adopt forward guidance, President Draghi noted that “a tightening of the policy stance may arise from developments in global bond markets that unduly spill over to the interest rate term structure in the Eurozone So far our forward guidance has managed to decouple Eurozone forward curves somewhat from developments in the US” (Draghi 2014).

In a new study, we argue that there is another aspect of financial globalisation which has been underappreciated in this debate (Georgiadis and Mehl 2016). In particular, along with the growth in the size of external balance sheets, economies’ net foreign currency exposures have risen as well – both advanced and emerging market economies have been increasingly net long in foreign currency on their external balance sheets.1 This may have profound economic implications. In particular, if economies are net long in foreign currency on their external balance sheets, monetary policy may impact output and subsequently inflation through valuation effects arising from exchange rate movements. Specifically, for illustrative purposes, consider an economy whose foreign assets are all denominated in foreign currency and whose foreign liabilities are all denominated in domestic currency. In this case, a tightening of local monetary policy that is followed by an appreciation of the domestic currency lowers the home-currency value of an economy’s foreign assets, but leaves the home-currency value of its foreign liabilities unchanged. As a result, a tightening of local monetary policy causes a fall in the economy’s net foreign asset position, which implies a negative wealth effect that should contract consumption and investment. Thus, even if financial globalisation might weaken the interest rate channel of monetary policy through global financial cycle effects, it may strengthen the exchange rate channel through net foreign currency exposure effects.

We investigate the impact of financial globalisation on monetary policy effectiveness as the outcome of these two opposing forces. We hence address the questions as to whether global financial cycle and net foreign currency exposure effects have been empirically relevant and, if so, which of these opposing forces has had a stronger impact on monetary policy effectiveness since the 1990s.

To answer these questions, we first estimate the response of output to a local monetary policy shock for a sample of economies with flexible exchange rates over 1999-2009.2 We then examine whether cross-country heterogeneities in monetary policy effectiveness can be explained by differences in economies’ global financial integration patterns. In particular, we consider the role of economies’ external balance sheets, which reflects their susceptibility to global financial cycle effects, and that of the currency exposures of economies’ external balance sheets, which capture their susceptibility to net foreign currency exposure effects.

We find empirical support both for global financial cycle and net foreign currency exposure effects on monetary policy effectiveness. On the one hand, economies which are more susceptible to global financial cycle effects display a weaker response of output to monetary policy. On the other hand, economies which are more net long in foreign currency exhibit a stronger response of output to a monetary policy shock (for more details, see Georgiadis and Mehl 2016).

We then back out the actual historical impact that financial globalisation has had on monetary policy effectiveness. We apply the estimates from the cross-section to the evolution of economies’ susceptibility to global financial cycle and net foreign currency exposure effects within economies over time. The results suggest that the net impact of financial globalisation varies across regions. Figure 1 indicates that the trough response of Eurozone output to a contractionary monetary policy shock has been reduced by less than 5%. In other words, financial globalisation has not markedly changed monetary policy effectiveness in the Eurozone since the late 1990s. In contrast, financial globalisation has amplified monetary policy effectiveness in the typical non-Eurozone advanced and emerging market economy – by our estimates, the trough output effect of a tightening in monetary policy has increased by no less than 25% due to financial globalisation.

Figure 1 Cumulated effects of global financial cycle and net foreign currency exposure on monetary policy effectiveness

These findings have implications for policy and academia. From a policy perspective, insofar as valuation effects on economies’ external balance sheets arising from exchange rate movements grow in importance, central banks might need to re-assess the way their monetary policy transmits to the economy. In particular, while the traditional interest rate channel might lose economic significance due to the increasing influence of global financial markets on domestic financial conditions, the exchange rate channel may grow in importance due to rising net foreign currency exposures of economies’ external balance sheets. As a result, the exchange rate channel matters not only because of its role for import and export prices, but also because of wealth effects. From an academic perspective, the finding that exchange rate valuation effects on economies’ external balance sheets have implications for the transmission of monetary policy suggests that these should become a standard element in DSGE models. Specifically, the rotation in the transmission channels of monetary policy may play an economically significant role in the design of optimal monetary policy and for the gains from international monetary policy coordination. Finally, future research should investigate possible heterogeneities in the importance of net foreign currency exposure effects across the public, household, corporate and financial sectors.

Authors’ note: The views expressed in this column are those of the authors. They do not necessarily reflect those of the ECB or the Eurosystem and should not be reported as such.

References

Benetrix, A, P Lane, J Shambaugh (2015) “International currency exposures, valuation effects and the Global Financial Crisis”, Journal of International Economics, 96: 98-109.

Bernanke, B (2007) “Globalization and monetary policy”, Speech at the Fourth Economic Summit, Stanford Institute for Economic Policy Research.

Bruno, V and H S Shin (2015) “Capital flows and the risk-taking channel of monetary policy”,Journal of Monetary Economics, 71: 119-132.

Draghi, M (2014) “Monetary policy communication in turbulent times”, Speech at the Conference De Nederlandsche Bank, 200 Years: Central Banking in the Next Two Decades.

Georgiadis, G and A Mehl (2016) “Financial globalization and monetary policy effectiveness”, Journal of International Economics, 103: 200-212.

Hausmann, R and U Panizza (2011) “Redemption or abstinence? Original sin, currency mismatches and counter cyclical policies in the new millennium”, Journal of Globalization and Development, 2: 1-35.

Meier, S (2013) “Financial globalization and monetary transmission”, Federal Reserve Bank of Dallas, Globalization and Monetary Policy Institute, Working Paper No 145.

Obstfeld, M (2015) “Trilemmas and trade-offs: Living with financial globalization”, BIS Working Paper No 480.

Passari, E and H Rey (2015) “Financial flows and the international monetary system”, Economic Journal, 584: 675-698.

Rey, H (2013) “Dilemma not trilemma: the global financial cycle and monetary policy independence”, Proceedings, Economic Policy Symposium, Jackson Hole, 1-2.

Shin, H S (2012) “Global banking glut and loan risk premium”, IMF Economic Review, 60: 155-192.

Woodford, M (2007) “Globalization and monetary control”, International Dimensions of Monetary Policy, NBER Chapters, National Bureau of Economic Research: 13-77.

Yellen, J (2006) “Monetary policy in a global environment”, Speech at The Euro and the Dollar in a Globalized Economy Conference.

Endnotes

[1] For more evidence on the extent of this phenomenon, see Hausmann and Panizza (2011) and Benetrix et al (2015).

[2] The impact of a contractionary local monetary policy shock on output is obtained from a mixed cross-section global VAR model with sign restrictions.