Since the beginning of the international financial crisis in major developed economies, central banks of these countries implemented several monetary policy (MP) measures, oriented to stabilize the financial system and mitigate the effects on the real side of the economy.

The speech of FED authorities is turning to consider the rising of the FED fund rates (FFR), phenomenon known as monetary policy normalization. This eventuality is considered an important topic among policy makers, given that a sharp increase could raise financial market volatility. Therefore, it reopens the question of how US monetary policy shocks spillover to rest of the world, in the current context of historically low interest rates levels.

In the case of Central America and the Dominican Republic (CADR), this is a relevant subject for policy makers in these economies, due to the important commercial linkage of CARD countries with the US economy, despite the low degree of financial development relative to other Emerging Market Economies in Latin America (LA).

This phenomenon reopens the subject on the empirics of international transmission of monetary policy shocks.

In a recent working paper[1], we analyze the potential impact of an increase in FFR on CADR economies. The empirical strategy used to study this phenomenon intends to measure the country-specific effects of US monetary policy shocks. Consists of a FAVAR approach with a sign-restriction identification of US monetary policy shock, where factors included are principal components. These common factors are extracted from a country data set of nearly 80 macroeconomic variables of CARD[2] countries, for the period 2003 - 2014.  We use Bayesian methods to estimate VAR coefficients and impose sign-restriction on the impulse response functions for the identification of US MP shocks.

Overall, our results indicate that a foreign interest rate innovation, measured by a one-time 25 basis point unexpected increase of the FFR, has a negative impact on main real domestic variables (Table 1 summarizes the qualitative response of macroeconomic variables for each economy).

For all countries under analysis, output, export and import growth rates fall. These results are in line with Jannsen and Klein (2011) which emphasize the importance of income absorption effect over the expenditure switching effect in countries with active exchange rate policies oriented to stabilize this variable. Nevertheless, the fall in import growth exceeds the fall in exports. As a result, trade balance improves for most countries considered, excluding El Salvador.

In addition, financial sector variables such as interest rates and risk premium increase, while money and credit demand decrease. There is no evidence of significant nominal and real exchange rates adjustment to the shock. Instead, data suggest that Central Banks react to the external shock by increasing interest rates across all countries and reducing net foreign reserves, thus conceding importance of exchange rate stability as a policy objective.

Table 1. Results Overview

[1] Checo, A.; S. Pradel; F. Ramírez. “Measuring the Effects of the ‘Normalization’ of US Monetary Policy on Central America and the Dominican Republic” Documentos de Trabajo 2015-4, Central Bank of the Dominican Republic.

[2] Nicaragua is excluded from the sample, due to lack of data prior to 2007.

References:

Jannsen, N., & Klein, M. (2011). The International Transmission of Euro Area Monetary Policy Shocks. The Kiel Institute for the World Economy. Working Paper No.1718