Working Papers

June 30, 2015

Systemic Risk: A New Trade-off for Monetary Policy?

Description: We introduce time-varying systemic risk in an otherwise standard New-Keynesian model to study whether a simple leaning-against-the-wind policy can reduce systemic risk and improve welfare. We find that an unexpected increase in policy rates reduces output, inflation, and asset prices without fundamentally mitigating financial risks. We also find that while a systematic monetary policy reaction can improve welfare, it is too simplistic: (1) it is highly sensitive to parameters of the model and (2) is detrimental in the presence of falling asset prices. Macroprudential policy, similar to a countercyclical capital requirement, is more robust and leads to higher welfare gains.

June 26, 2015

Global Financial Spillovers to Emerging Market Sovereign Bond Markets

Description: Foreign holdings of emerging markets (EMs) government bonds have increased substantially over the last decade. While foreign participation in local-currency sovereign bond markets provides an additional source of financing and reduces sovereign yields, it raises concerns about increased sensitivity of yields to shifts in market sentiment. The analysis in this paper suggests that foreign participation and an undiversified investor base transmit global financial shocks to local-currency sovereign bond markets by increasing yield volatility and, beyond a certain threshold, amplify these spillovers. These estimates are robust to a range of econometric techniques including panel smooth threshold regression.

June 26, 2015

Assessing Default Risks for Chinese Firms: A Lost Cause?

Description: Assessing default risks for Chinese firms is hard. Standard measures of risk using market indicators may be unreliable because of implicit guarantees, the large role played by less-informed investors, and other market imperfections. We test this assertion by estimating stand-alone 1-year default probabilities for non-financial firms in China using an equity-based structural model and debt costs. We find evidence that the equity measure of default risk is sensitive to a firm’s balance sheet health, profitability, and ownership; specifically, default probabilities are higher for weaker, less profitable, and state-owned firms. In contrast, measures based on the cost of debt seem largely detached from fundamentals and instead determined by implicit guarantees. We conclude that for individual firms, equity-based measures, while far from perfect, provide a better measure of stand-alone default risks than borrowing costs.

June 26, 2015

Does Easing Monetary Policy Increase Financial Instability?

Description: This paper develops a model featuring both a macroeconomic and a financial friction that speaks to the interaction between monetary and macro-prudential policies. There are two main results. First, real interest rate rigidities in a monopolistic banking system have an asymmetric impact on financial stability: they increase the probability of a financial crisis (relative to the case of flexible interest rate) in response to contractionary shocks to the economy, while they act as automatic macro-prudential stabilizers in response to expansionary shocks. Second, when the interest rate is the only available policy instrument, a monetary authority subject to the same constraints as private agents cannot always achieve a (constrained) efficient allocation and faces a trade-off between macroeconomic and financial stability in response to contractionary shocks. An implication of our analysis is that the weak link in the U.S. policy framework in the run up to the Global Recession was not excessively lax monetary policy after 2002, but rather the absence of an effective regulatory framework aimed at preserving financial stability.

June 25, 2015

Estimation and out-of-sample Prediction of Sudden Stops: Do Regions of Emerging Markets Behave Differently from Each Other?

Description: We identify episodes of sudden stops in emerging economies and estimate the probability to observe them. Sudden stops are more likely when global growth falters, risk aversion in financial markets rises, and vulnerabilities in the external and financial sectors increase. However, the significance of the explanatory variables vary across regions. In Latin America and Eastern Europe, gross capital inflows are more responsive to changes in global growth than in Asia. Trade linkages tend to be more important than financial linkages in Eastern Europe, while in Asia and Latin America the opposite is true. The model captures only a third of sudden stops outside the estimation sample, but issues reliable sudden stop signals.

June 25, 2015

What Really Drives Public Debt: A Holistic Approach

Description: This paper presents a novel approach to detail the propagation of shocks to public debt. The modeling technique involves a structural vector auto-regression (SVAR) estimator with an endogenous debt accumulation equation. It explores how the main drivers of sovereign debt dynamics—the primary balance, the interest rate, growth and inflation—interact with each other. Such analysis is particularly useful for debt sustainability analysis. We find that some interactions exacerbate the impact of shocks to the accumulation of debt, while others act to stabilize debt dynamics. Furthermore, the choice of monetary policy regime plays an important role in these debt dynamics – countries with constrained monetary policy are more at risk from changes in market sentiment and must rely much more on fiscal policy to constrain debt.

June 25, 2015

The Journey to Inflation Targeting: Easier Said than Done The Case for Transitional Arrangements along the Road

Description: Countries with evolving monetary regimes that decide to embark on “the Journey to inflation targeting” may not be able to adopt a full-fledged inflation targeting regime immediately. Those countries would be better off adopting transitional arrangements that take advantage of the informational content of monetary aggregates, developing an economic analysis capacity, and concentrating on monetay operations aimed at steering money market interest rates. This approach would allow the central bank to buy time for developing the building blocks for effective monetary policy, support transparent central bank communication, and limit the potential for undesirable outcomes along the road.

June 24, 2015

Lower for Longer: Neutral Rates in the United States

Description: We use a semi structural model to estimate neutral rates in the United States. Our Bayesian estimation incorporates prior information on the output gap and potential output (based on a production function approach) and accounts for unconventional monetary policies at the ZLB by using estimates of “shadow” policy rates. We find that our approach provides more plausible results than standard maximum likelihood estimates for the unobserved variables in the model. Results show a significant trend decline in the neutral real rate over time, driven only in part by a decline in potential growth whereas other factors (including excess global savings) matter. Neutral rates likely turned negative during the Global Financial Crisis and are expected to increase only gradually looking forward.

June 24, 2015

Global Food Prices and Domestic Inflation: Some Cross-Country Evidence

Description: This paper provides a broad brush look at the impact of fluctuations in global food prices on domestic inflation in a large group of countries. For advanced economies, we find that these fluctuations have played a significant role over the period from 1960 to the present, but the impact has declined over time and become less persistent. We also find that the more recent global food price shocks occurred in the 2000s had a much bigger impact on emerging than on advanced economies. This larger impact could reflect the larger share of food in the consumption baskets in emerging economies on average than in advanced economies, and less anchored inflation expectations in emerging economies than in advanced economies.

June 24, 2015

Inflation-Forecast Targeting: Applying the Principle of Transparency

Description: Many central banks in emerging and advanced economies have adopted an inflation-forecast targeting (IFT) approach to monetary policy, in order to successfully establish a stable, low-inflation environment. To support policy making, each has developed a structured system of forecasting and policy analysis appropriate to its needs. A common component is a model-based forecast with an endogenous policy interest rate path. The approach is characterized, among other things, by transparent communications—some IFT central banks go so far as to publish their policy interest rate projection. Some elements of this regime, although a work still in progress, are worthy of consideration by central banks that have not yet officially adopted full-fledged inflation targeting.

Notes: Supplemental Annex