Appendix. Spillovers and Synchronicity in the U.S. and the Euro Area: Developments During Selected Monetary Policy Cycles
The easing cycle in 2001–03 is an example of synchronous real and monetary conditions in the U.S. and the EA:
After years of rapid expansion, economic activity in the U.S. peaked in 2000:Q2, with annualized year-over-year growth reaching 5¼ percent. By end-2000, growth had collapsed to less than 3 percent, and the economy continued to decelerate in 2001, reaching a cyclical low toward the end of the year. The recovery was rather bumpy until mid-2003 but consolidated by early 2004. Despite the sharp deceleration in the second half of 2000, the Federal Reserve kept the policy rate constant until December and began a gradual easing in January 2001. The slow monetary easing and a surprising sharp increase in the term premium—from less than 0.4 percent in January 2001 to about 1.7 percent by the summer of 2002 (see chart on the right)—likely prevented monetary conditions to ease as warranted by cyclical developments (see Figure A1.1 panels 1, 3, and 5). The downward pressure from domestic real shocks to U.S. yields point to negative surprises on economic activity throughout 2001 (panel 3, dark red of Figure A1.1)—with somewhat volatile perceptions, likely associated with volatility in underlying data, as noted above. The framework also captures the slow reaction by the Federal Reserve and the increase in the term premium as a positive contribution of money shocks to yields.
The EA economy had also experienced a rapid recovery starting in late 1998, with the economy peaking during the first quarter of 2001 (at an annualized year-over-year rate of 5½ percent). However, growth turned around in the second quarter and bottomed out in early 2002. Activity remained subdued until mid-2003, when a recovery began to take place. The ECB began a monetary easing cycle in early 2001, but it interrupted it in November of that year, keeping the policy interest rate constant for a year despite weak economic activity (see Figure A1.1 panels 2, 4, and 6). The negative contribution of domestic real shocks to EA yields reflect persistent negative surprises on the economic outlook throughout 2001, which became larger during 2002 and early 2003. Panel 6 points to increasing upward pressure on yields from money shocks in late 2001, likely reflecting the interruption of monetary policy easing by the ECB. The positive contribution of domestic money shocks stabilized in late 2002, however, as the ECB resumed its loosening of monetary policy. This period was characterized by large spillovers from the U.S. to the EA: money spillovers were large (light blue in panel 6 of Figure A1.1), and real spillovers were smaller but significant (light red in panel 4 of Figure A1.1). Spillovers from the EA to the U.S. were more modest: considerable in size for real shocks (see Figure A1.1, light red in panel 3) and negligible for money shocks (see Figure A1.1 light blue in panel 5).
The easing cycle in 2007–09 is an example of asynchronous real and monetary conditions in the U.S. and the EA:
As the U.S. subprime crisis unraveled with larger-than-expected adverse effects on the real economy, domestic real shocks started to put downward pressure on U.S. 10-year yields (dark red bars in panel 3 of Figure A1.2). The negative contribution of these shocks increased in the first quarter of 2008, as fears of a deeper-than-anticipated recession emerged, when the Federal Reserve provided an emergency loan to Bear Sterns to avert a sudden collapse of the company. In the second half of 2008, another wave of domestic real shocks in the U.S. started to drive yields down, this time reflecting negative growth surprises associated with the placement of Fannie Mae and Freddie Mac into conservatorship, the collapse of Lehman Brothers and the bailout of AIG. Indeed, U.S. economic activity contracted sharply during this period, with average quarterly growth rates between 2007:Q3 and 2008:Q3 falling to virtually zero. The contribution of domestic U.S. money shocks was initially negative but very small, likely reflecting the fast and sharp easing of monetary policy stance at the onset of the crisis (dark blue bars in panel 5 of Figure A1.2). However, toward the second half of 2008, domestic money surprises started to push U.S. 10-year yields up, possibly capturing the liquidity squeeze in financial markets around the collapse of Lehman Brothers, as well as market participants’ misperceptions (or incomplete information) about the strategies authorities would follow toward stressed financial institutions.
In 2007, growth held up relatively well in the EA, as captured by the positive contribution of real domestic shocks to EA yields (dark red bars in panel 4 of Figure A1.2). However, output growth fell sharply in the second half of 2008, as the recession in the US generated negative growth spillovers to the EA (light red bars in panel 4 of Figure A1.2). Notwithstanding the deterioration in economic activity, the ECB kept its policy rate on hold through 2008:Q3. Market participants likely perceived the monetary policy stance as being “too tight” given the weak cyclical position, a phenomenon which our model captures as a positive contribution to yields from domestic money shock (dark blue bars in positive territory of panel 6 in Figure A1.2.). Subsequently, as the EA economy fell into recession following the collapse of Lehman Brothers, the ECB started an easing cycle, cutting its policy rate aggressively by more than 400 bps between September 2008 and May 2009. These actions helped reduce EA 10-year yields (dark blue bars in negative territory of panel 6 in Figure A1.2.).
Investor risk-aversion increased sharply with news about the vulnerabilities of large U.S. financial institutions (Bear Stearns, Lehman Brothers, etc.), pushing yields down (“risk-off”) in both the U.S. and EA (yellow bars in panels 1 and 2 of Figure A1.2).
This period was characterized by important real spillovers from the U.S. to the EA, notably in the second half of 2008. In contrast, real spillovers from the EA to the U.S. were small. As regards to money shocks, there were significant two-way spillovers between the two economies, which were mostly asynchronous. Therefore, external money shocks tended to dampen the effects of domestic ones on the economy’s own yields.
The results of our analysis for the 1994 and 1999 episodes are consistent with Ehrmann and Fratzscher (2002, 2005). The authors find that U.S. markets did not react to euro area markets before 1999 but have, since then, become highly responsive to developments in Europe. One possible explanation is that, through the formation of the Economic and Monetary Union (EMU) in 1999, a single European market replaced national markets, allowing market participants in the U.S. to fully capture developments in Europe (as opposed to following a large number of variables giving independent and potentially conflicting signals, prior to EMU). The higher interdependence between the U.S. and EA markets could also be explained by the increased real integration of the two economies.
The 1994 U.S. tightening episode is characterized by large spillovers to Europe:
The U.S. economy began to decelerate in 1990, and experienced a big recession in 1991. The economy entered a swift recovery in 1992, but it had its ups and downs, reaching a soft patch by mid-1993. By early 1994, the recovery accelerated sharply, reaching year-on-year growth rates above 4 percent by the second quarter. Concurrently, the Federal Reserve initiated a 10-quarter tightening cycle in February. Despite the incipient acceleration, the move by the Federal Reserve surprised markets. The recovery continued to display erratic dynamics, with growth decelerating again in late 1994, becoming tepid in 1995, and gathering strength by mid-1996.
Consistent with the characteristics of the recovery, our framework shows a somewhat irregular pattern of real shocks (Figure A1.3, panel 3) in the U.S., with positive growth surprises—at the time in which very rapid growth rates had likely surprised some market participants—and mostly negative surprises beginning in the second half of 1994—at a time in which the recovery during the first half of the year partially reversed. Most of the tightening in early 1994 comes as a money shock (Figure A1.3, panel 5), i.e. a tightening that is not warranted by news on the real front, and seems consistent with the surprise that the swift move by the Federal Reserve caused in markets. A significant portion of the tightening in Europe was also related to money spillovers from the United States (Figure A1.3, panel 6, light blue bars).
The 1999 episode is characterized by large spillovers from the EA to the U.S.:
By mid-1999, when the Federal Reserve initiated a tightening cycle, the economy had experienced a prolonged expansion, displaying 13 consecutive quarters of year-on-year growth above 4 percent. Despite a brief deceleration during the third quarter, economic growth gathered new impetus by end 1999—year-on-year quarterly growth reached 5¼ percent by the second quarter of 2000. However, by end 2000, the economy began to decelerate swiftly. In Europe, the economy reached the final stage of a deceleration that had began in 1997, and growth began to pick up modestly in early 1999. The recovery, though, accelerated towards the end of the year and in early 2000. Meanwhile, in November 1999, the European Central Bank began an aggressive tightening cycle that took the main refinancing rate from 275 to 475 basis points by October 2000.
Our framework displays positive real shocks in the U.S. in early 1999, and negative surprises that coincide with the brief deceleration during the third quarter of that year (Figure A1.4, panel 3, dark red bars). Positive real surprises resume as the economy accelerated sharply towards the end of 1999 and early 2000. Monetary tightening by the Federal Reserve was relatively mild in 1999, with our framework not showing significant money shocks in that year (Figure A1.4, panel 5, dark blue bars). However, spillovers from Europe become significant in the second half of the year (Figure A1.4, panel 5, light blue bars), as markets perceived more hawkish monetary conditions after the inception of the euro (Figure A1.4, panel 6, dark blue bars).
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We are extremely grateful to Chanpheng Fizzarotti, Daniel Rivera Greenwood and Ava Yeabin Hong for their invaluable research assistance. The note benefited from discussions and support from Prakash Loungani, Gian Maria Milesi-Ferreti and Emil Stavrev. We received insightful comments from Aqib Aslam, Nigel Chalk, Rupa Duttagupta, Romain Duval, Tommaso Mancini Griffoli and Sergio Sola (IMF), Juan Rubio-Ramirez (Duke University), Sebastian Weber (ECB), Juan Yepez (Pichincha). We also thank the IMF Spillover Taskforce for their insightful comments. All remaining errors are ours.
This working paper is an expanded version of a background note prepared for the 2015 Spillover Report, see https://www.imf.org/external/pubs/ft/pdp/2015/pdp1501.pdf
Other examples are Chen and others (2012, 2014a, 2014b), who estimate a global VAR and assume the U.S. is the dominant economy. The authors find that the Fed’s QE helps prevent recessions and has heterogeneous cross-border effects that vary across regions. Georgiadis (2015) also estimates a global VAR and finds significant effects from U.S. monetary policy, with the magnitude of spillovers depending on a number of country characteristics, including financial integration, trade openness, the exchange rate regime, industry structure, financial market development and labor market rigidities.
The identification of exogenous money shocks through de-jure policy changes may be more difficult after the inception of UMP and due to frequent reasssessements of the term premium in long term yields. This strategy may miss changes in monetary conditions outside announcement dates. Some papers also assume that policy annoucements are fully unanticipated, while UMP news come out gradually before the announcement, or are explained through press conferences after the announcement. There are exemptions that disentangle the expected and unexpected elements in announcements, notably Chen and others (2014).
In this paper, monetary conditions refer to the evolution of long-term yields—as opposed to short-term rates—which reflect conventional and unconventional monetary policy developments, exogenous shocks to the term premium, and inflation surprises, including in response to oil price shocks. In other words, changes in monetary conditions can reflect the dynamics of any of these factors.
In contrast, approaches that rely on the identification of money shocks on a country-by-country basis would not allow for the analysis of synchronicity and spillovers between systemic economies, as purely domestic shocks would not be well identified.
Conversely, approaches that use narrow definitions of monetary policy—i.e., based on the analysis of decisions on monetary policy rates—cannot address this challenge.
In general, there is agreement that the VIX, although an index of volatility in U.S. markets, captures developments that prompt global investors to search for safe haven assets (see Bekaert, Hoerova, and Lo Duca, 2013). Since investors can move to safe assets in both Europe and the U.S., movements in the VIX can, in principle, impact yields in both economies.
Bekaert and others (2013) suggest that there is a two-way interaction between real and monetary developments and the VIX, which raises endogeneity issues in trying to disentangle movements in the VIX associated with “pure” risk-appetite shocks. The proposed methodology strips out the risk-appetite component associated with identified shocks to the VIX. Note, however, that the data still contains information on autonomous shocks to stock prices and bond yields that can affect the VIX.
Assuming that shocks in both the U.S. and EA have contemporaneous positive cross-border spillovers within asset classes does not change the results. See Section V on robustness.
Following Matheson and Stavrev (2014), the model is estimated in levels with one lag. The variables have a cointegration vector, which is incorporated in the estimation of the model in levels. Since, the impulse responses are stationary and the VAR is stable, estimating without first-differencing is acceptable. Finally, standard tests suggest that one lag length is optimal.
The model identification issue is not specific to sign restricted VARs (Fry and Pagan, 2010). For instance, if a recursive ordering is used to identify the model, many such orderings can have the same fit to the data.
EPFR data track retail and institutional portfolio flows by country and asset type. The database covers some 11,000 equity funds and about 4,500 fixed income funds, but the coverage for institutional investment flows is relatively small. Therefore, EPFR institutional portfolio flows may not be a good proxy for the entire universe of institutional investment flows.
The contribution of domestic real shocks to changes in the U.S. yields is in line with consensus forecasts revisions of U.S. growth. Further, the correlation of U.S. real shocks with the U.S. dollar Citi Surprise Index is positive and statistically significant.
The correlation of the monthly changes in the contribution of risk-appetite shocks to movements in U.S. and EA yields is 0.97, reflecting the global nature of these shocks.
For transmission channels of spillovers from monetary policy shocks, see Chen and others (2014) and Chen and others (forthcoming).
The supply of international dollar credit is largely influenced by the behavior of non-US international banks, particularly those headquartered in Europe (McCauley and others, 2015; and Ivashina and others, 2015) as they intermediate the lion’s share of such credit flows. See also Rey (2013) and Cerutti and others (2014).
The correlations between the monthly purged data and the daily purged data aggregated into a monthly frequency ranges between 0.97 (EA stock prices) and 0.99 (for EA yields and U.S. stock prices). The estimation of U.S. and euro area real and money shocks, as well as their spillover effects to EMNS, therefore remains broadly unchanged across the two methodologies. Note that to ensure orthogonality of the shocks for which spillovers to EMNS are examined, the sign restricted VAR and the panel VAR need to be estimated at the same frequency (monthly in this case).
For instance, assume the term premium in the U.S. is perceived to be too low (and hence likely to adjust) but not in the EA. In this context, a money shock in the U.S. may lead to lower yields in the EA, as safe-haven investors shift away from U.S. to EA bonds.