The strength of monetary policy in emerging markets

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The power of monetary policy in developing economies is still a subject of discussion. Concerns persist regarding the efficacy of monetary policy in these markets, mainly due to limited financial development and weaker institutional trust. Influential studies have highlighted the significant impact of global financial forces, particularly those driven by US monetary policy, on financial conditions in emerging markets, regardless of whether they have flexible exchange rates. Recent research has revealed that a tightening of US monetary policy leads to higher borrowing and lending rates in emerging markets, even when local central banks respond by reducing policy rates.

The evidence has sometimes been interpreted as suggesting challenges in the transmission of monetary policy in emerging markets. It has been proposed that the strength of the global financial cycle could turn Mundell’s Trilemma into a Dilemma, where countries can only maintain autonomy in monetary policy by regulating capital flows or implementing strict macroprudential frameworks. However, despite the impact of global financial shocks on emerging markets’ financial conditions, it does not necessarily mean that monetary policy in these markets can no longer influence domestic economic and financial conditions. While global financial shocks present challenges for central banks in emerging markets, domestic monetary policy still plays a role in steering economic conditions.

Assessing the transmission of monetary policy in developing economies requires the identification of domestic monetary policy shocks, a task that can be quite challenging. Advanced economies have successfully used high-frequency identification techniques, but these methods face obstacles in emerging markets due to limited market liquidity.

To address these challenges, a recent study by Checo et al. (2024) introduced a new set of monetary policy shocks for 18 emerging markets by analyzing analysts’ forecasts of policy rate decisions. By leveraging forecast errors, they were able to isolate variations in monetary policy decisions independent of economic developments. The study found that analysts tend to provide accurate forecasts closer to policy meetings when the decision is more uncertain.

In analyzing the effects of monetary policy shocks on financial markets, the research discovered pronounced and lasting impacts on sovereign bond yields. A percentage point monetary policy shock raised bond yields significantly, although the effects on other financial variables like bond spreads, exchange rates, and stock prices were short-lived.

Further analysis revealed that monetary policy impacts macroeconomic conditions, aligning with theoretical predictions. Tightening monetary policy led to declines in industrial production, gradual increases in the unemployment rate, and reduced inflationary pressures. The appreciation of the exchange rate in response to a monetary policy tightening was also observed.

Moreover, the study explored the transmission of monetary policy on firm-level data, showing that monetary policy had a stronger effect on investment decisions by highly leveraged firms. The study also suggested that firms with lower liquidity or those that do not pay dividends exhibited more significant investment responses to monetary policy shocks, underscoring the role of financial frictions in shaping the impact of monetary policy in emerging markets.

In conclusion, the research provides optimistic findings about the effectiveness of monetary policy transmission in emerging markets. By demonstrating the influence of monetary policy on financial markets, macroeconomic conditions, and firm-level decisions, the study suggests that monetary policy in developing economies may have a more substantial impact on domestic economic conditions and can counter global financial shocks more effectively than commonly perceived.Global tightening of monetary policies serves as an additional sign of this success, potentially supported by enhancements in macroprudential and monetary policy frameworks as noted by Sandri et al. (2020) and Kalemli-Özcan and Unsal (2019).

Authors’ note: The opinions presented here are those of the authors and should not be associated with the BIS or the IMF.


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