Monetary policy spillovers, capital controls and exchange rate flexibility, and the financial channel of exchange rates

Focus

The "trilemma hypothesis" would make it impossible for a country to have, at one and the same time, a fixed foreign exchange rate, free cross-border flows of capital and an independent monetary policy. To test this hypothesis, we estimate Taylor rule-type monetary policy reaction functions for 47 advanced and emerging market economies from January 2002 to December 2018. The Taylor rule-type factors we look at are the lagged policy rate, real-time forecasts for GDP growth and inflation, the VIX index, global commodity prices and the base-country policy rate. Then we assess how sensitive local policy rates are to those in the base country, across different degrees of exchange rate flexibility and capital account openness.

Contribution

Previous literature on the trilemma suggests that flexible exchange rates increase the freedom of monetary policymakers to set policy rates. More recently, a different strand of the literature suggested that the global financial cycle has an important influence on financial conditions even in economies with flexible exchange rates. Thus, it has been argued that policymakers face a dilemma instead of a trilemma. This paper considers a different mechanism based on the financial channel of exchange rates. In particular, the foreign currency exposures of local borrowers, combined with flexible exchange rates, might amplify spillovers from the monetary policy of the base country. If these spillovers tend to accentuate vulnerabilities, local policymakers may find it best to dampen exchange rate fluctuations by imitating the base country's monetary policy.

Findings

In line with the traditional trilemma concept, we find that flexible exchange rates and restrictions on capital flows make local policy rates less sensitive to those of the base country. However, we also find evidence that the financial channel of exchange rates makes local policymakers less likely to exploit the monetary autonomy conferred by a flexible exchange rate. In particular, the local policy rate of an economy with a flexible exchange rate will be more sensitive to the base country policy rate when it has negative foreign currency exposures, in particular when these stem from portfolio debt and bank liabilities, and when base country monetary policy is tightened.

Abstract

We assess the empirical validity of the trilemma or impossible trinity in the 2000s for a large sample of advanced and emerging market economies. To do so, we estimate Taylor rule-type monetary policy reaction functions, relating the local policy rate to real-time forecasts of domestic fundamentals, global variables, as well as the base-country policy rate. In the regressions, we explore variations in the sensitivity of local to base-country policy rates across different degrees of exchange rate flexibility and capital controls. We find that the data are in general consistent with the predictions from the trilemma: both exchange rate flexibility and capital controls reduce the sensitivity of local to base-country policy rates. However, we also find evidence that is consistent with the notion that the financial channel of exchange rates highlighted in recent work reduces the extent to which local policymakers decide to exploit the monetary autonomy in principle granted by flexible exchange rates in specific circumstances: the sensitivity of local to base-country policy rates for an economy with a flexible exchange rate is stronger when it exhibits negative foreign currency exposures which stem from portfolio debt and bank liabilities on its external balance sheet and when base-country monetary policy is tightened. The intuition underlying this finding is that it may be optimal for local monetary policy to mimic the tightening of base-country monetary policy and thereby mute exchange rate variation because a depreciation of the local currency would raise the cost of servicing and rolling over foreign currency debt and bank loans, possibly up to a point at which financial stability is put at risk.

JEL codes: F42, E52, C50

Keywords: Trilemma, financial globalisation, monetary policy autonomy, spillovers