Capital flows and monetary policy trade-offs in emerging market economies

Summary

Focus

Emerging market economies (EMEs) commonly combine inflation targeting monetary policy regimes with macroprudential tools, capital flow management measures and FX intervention, to meet the challenges they face from swings in capital flows. These swings raise difficult trade-offs for monetary policy and require policymakers to resort to complementary policy tools to enhance macro-financial stability. We provide a characterisation of these trade-offs, distinguishing between times of stress and normal times when vulnerabilities build up, and assess how complementary policy tools can address them.

Contribution

We set out a small open-economy model incorporating key features of EMEs' economic and financial structure: a high exchange rate pass-through to import prices, low pass-through to export prices and shallow domestic financial markets in the form of occasionally binding leverage constraints. As a consequence of the latter, large capital outflows induced by a sudden tightening in global financial conditions give rise to sudden stops. We analyse monetary policy trade-offs and derive the optimal conduct of monetary policy as well as of macroprudential policy, capital flow management policy and central bank bond market and foreign exchange (FX) intervention.

Findings

During a sudden stop, the central bank faces an intratemporal trade-off as output declines while inflation rises. In normal times, there is an intertemporal trade-off as the risk of a future sudden stop forces the central bank to factor financial stability considerations into its policy conduct. Leaning against capital flows and domestic leverage is a key feature of optimal monetary policy aimed at medium-term macroeconomic stability. Macroprudential policy, capital flow management measures and FX intervention mitigate both intra- and intertemporal trade-offs. Bond market interventions can further alleviate constraints in a sudden stop. Fiscal policy also plays a key role. A higher level of public debt and a weaker fiscal policy imply greater leverage and hence greater tail risk for the economy. This worsens the intertemporal trade-off and induces a tighter monetary policy stance, with the aim of leaning against these effects.

Abstract

We lay out a small open economy model incorporating key features of EME economic and financial structure: high exchange rate pass-through to import prices, low pass-through to export prices and shallow domestic financial markets giving rise to occasionally binding leverage constraints. As a consequence of the latter, a sudden stop with large capital outflows can give rise to a financial crisis. In the sudden stop, the central bank faces an intratemporal trade-off as output declines while inflation rises. In normal times, there is an intertemporal trade-off as the risk of a future sudden stop forces the central bank to factor financial stability considerations into its policy conduct. The optimal monetary policy leans against capital flows and domestic leverage. Macroprudential, capital flow management and central bank balance sheet policies can help to mitigate both intra- and intertemporal trade-offs. Fiscal policy also plays a key role. A higher level of public debt and a weaker fiscal policy imply greater leverage and hence greater tail risk for the economy.

JEL classification: E5, F3, F4. 

Keywords: capital flows, monetary policy trade-offs, emerging market economies.