Journal Issue

Monetary Policy Cyclicality in Emerging Markets

International Monetary Fund. Research Dept.
Published Date:
September 2013
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Donal McGettigan, Kenji Moriyama, and Chad Steinberg

Procyclical policy has been a problem for emerging markets (EMs). This contrasts sharply with advanced markets (AMs), where policies tend to be countercyclical. Much attention has been given to the cyclical nature of fiscal policy in emerging markets. The literature provides ample evidence that fiscal policy in emerging markets has been procyclical, but with recent work finding it has become less so due to stronger institutions (Gavin and Perotti, 1997; Lane, 2003; Akitoby and others, 2004; Kaminsky, Reinhart, and Végh, 2005; Talvi and Végh, 2005; Alesina, Campante, and Tabellini, 2008; Ilzetzki and Végh, 2008; and Frankel, Végh, and Vuletin, 2012).

By contrast, the literature on monetary policy cyclicality in emerging markets is sparse. In parallel to the fiscal literature, these studies contrast the countercyclical nature of monetary policy in advanced markets with the procyclical stance of emerging markets. Kaminsky, Reinhart, and Végh (2005) present the first systematic effort to document empirically the cyclical properties of monetary policy in emerging markets using data for 104 countries from 1960 to 2003. They show a clear contrast between countercyclical monetary policy in advanced markets and a procyclical stance in emerging markets. In a more recent paper, Coulibaly (2012) concentrates on the behavior of monetary policy during crisis periods using data for 188 countries from 1970 to 2009. His results confirm that advanced markets had, during past crises, conducted countercyclical monetary policy, but that emerging markets tended to tighten monetary policy during crises. He finds, however, that emerging markets conducted more countercyclical policy during the 2008–09 period. He also finds that stronger macroeconomic fundamentals, lower vulnerabilities, greater openness, and, most importantly, financial reforms and inflation targeting, helped the move to countercyclical monetary policy among emerging markets. Likewise, Végh and Vuletin (2012) find evidence of emerging markets “graduation” on the monetary policy side. In a study covering 68 countries for the period 1960–2009, they find that more than a third of emerging markets graduated to countercyclical monetary policy in the 2000s, on top of the third that already had such policies in place. (Only 7 percent reverted to procyclical monetary policy.) They relate this move to the success, in many emerging markets, of overcoming what they term the “fear of free falling.” Where this fear is present, the policymaker raises interest rates to defend the currency in crisis times, which precludes the possibility of using monetary policy to stimulate the economy. They in turn relate the fear of free falling to institutional quality and find a strong relationship between the two, with fear of free falling subsiding as reforms take hold. Finally, in a narrower study, Takáts (2012) looks at monetary policy from 2000 to 2011 for 14 emerging markets that have adopted inflation targeting and finds that most emerging markets were able to pursue countercyclical monetary policy during the recent decade.

Our research builds on this literature. Our comprehensive dataset covers 84 countries—35 advanced markets and 49 emerging markets—from 1960 to 2011 (McGettigan and others, 2013). Our analysis confirms that monetary policy in advanced markets is typically more countercyclical than in emerging markets, but that both advanced markets and emerging markets have become more countercyclical over the past half century. Among other methods, we use the four-quadrant “graduate” approach employed by Végh and Vuletin (2012), which shows movements in monetary policy cyclicality. From Figure 1, it is clear that emerging markets have adopted increasingly countercyclical monetary policy over time. The figure shows the cyclicality of monetary policy from 1960 to 1995 on the horizontal axis, and from 1996 to 2007 on the vertical axis. This figure divides covered countries into four “quadrant” categories (four black sublabels). The countries in the top-right quadrant are countries that have been countercyclical over the past fifty years, and unsurprisingly, include many advanced markets. From 1960 to 1995, 68 percent of advanced markets (in red) were implementing counter-cyclical monetary policy (countries situated on the right of the figure) compared to 50 percent for emerging markets (in blue). Between 1996 and 2007, advanced markets have become almost uniformly countercyclical and more emerging markets (60 percent) were implementing counter-cyclical monetary policy (countries in the top part of the figure).

Figure 1.Transitions

Source: IMF staff calculations

Following the advent of the global crisis, however, and in contrast to the findings of Coulibaly (2012), we find that monetary policy has become decidedly less countercyclical across both advanced markets and emerging markets according to our CoMP1 measure (Figure 2). For advanced markets this, in part, likely reflects central banks running into the interest rate lower bound. For emerging markets, global food and commodity price shock may have played a role given their large weight in the CPI baskets of many emerging markets. Coming into the crisis, the central banks in emerging markets were concerned with second round effects from the run-up in commodity prices, meaning that a full response to headline commodity-related inflation increases was not needed. After the crisis hit, inflation fell quickly with commodity prices, but capital also started to quickly flow back to the core. As a result, there was less room for central banks in emerging markets to loosen monetary policy, and less need from a strictly inflationary viewpoint, increasing measured monetary policy procyclicality.

Figure 2.CoMP over Time

Source: IMF staff calculations

Robustness tests confirm our findings. Using variants of the Taylor rule, we find a strong relationship between our correlation measures and the estimated coefficients from Taylor rules (i.e., on the output gap). Moreover, our CoMP measure is very strongly correlated to the correlation between monetary aggregates (private credit) and output gaps over the sample period, implying that CoMP is a good proxy for monetary policy stance even if the stance is characterized by monetary aggregates (see Figure 3).

Figure 3.Comparison of Our CoMP Measures and Correlation Between Private Credit and Output Gap 1960–2009

Source: IMF staff calculations

Past research has also attempted to explain both the differences across emerging markets and over time in the degree of monetary policy cyclicality. Coulibaly ascribes improvements in countercyclicality in emerging markets to macroeconomic fundamentals, vulnerabilities, financial sector reform, and inflation targeting (IT). Végh and Vuletin (2012) regard the lack of exchange rate flexibility, in turn related to institutional quality, as a key determinant. Our research relates monetary policy cyclicality (CoMP) to a variety of explanatory variables, including the monetary policy regime, the exchange rate regime, financial market development, and institutional strength.

We find that IT and institutions are significant and robust drivers of monetary policy countercyclicality. Specifically, we find that countries that have implemented IT regimes and/or have improved their institutions tend to have more countercyclical monetary policy. These results withstand a multitude of specification and robustness checks.

The results are also economically significant, carrying policy implications. Implementation of IT is found to improve the correlation between real interest rates and output by nearly 0.6–0.7. That is a surprising 1.3–1.5 standard deviation improvement. Therefore, the adoption of IT, and all that this typically involves, should help substantially improve effectiveness of monetary policy in stabilizing the economy. Similarly, a one-standard deviation improvement in institutional quality is associated with a quarter standard deviation improvement in monetary policy countercyclicality. Although these results are based on within regression results, the cross-section is equally convincing.

Only with deep financial systems can emerging markets with flexible exchange rate regimes eliminate procyclicality. This could be linked to “fear of floating” in less financially developed emerging markets and improved monetary transmission mechanisms in emerging markets with more developed financial sectors.

The results were surprisingly weak for many remaining explanatory variables analyzed. The bilateral estimation for exchange rate regime and financial deepening are both statistically insignificant when considered individually. Variables that are not shown, but were also found to be insignificant under various specifications, include private credit, capital account openness, terms of trade shocks, the fiscal deficit, public debt, and GDP growth volatility.

Scatter plots confirm that more countercyclical monetary policy is associated with lower levels of output volatility (Figure 4). We also investigate the impact on inflation volatility but results are inconclusive despite a tendency for both output variability and inflation variability to be highly correlated. Regression analysis substantiates that this result is robust to controls for external volatility. These findings are also consistent with previous work on emerging markets. Lane (2003), for example, shows that procyclical macroeconomic policies in emerging markets have been associated with more extreme cyclical fluctuations in output.

Figure 4.Log Output Volatility for EMs, 1996–2007

Source: IMF staff calculations

In conclusion, recent research, including at the IMF, confirms that emerging markets have adopted increasingly countercyclical monetary policy over time, driven by inflation targeting and better institutions. This countercyclical policy is associated with less volatile output, suggesting large economic benefits.


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Cyclicality of Monetary Policy (CoMP) is derived as the 10-year window of rolling correlations between the real interest rate (nominal interest rate minus actual inflation) and the output gap.

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