United States: Selected Issues
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The size and sources of international spillovers of activity remain subject to significant uncertainty. This Selected Issues paper uses a new approach to differentiating these effects using disturbances to a diverse group of small industrial countries as a proxy for global shocks. The results from the baseline vector autoregressions suggest that shocks to the United States are significant for foreign activity. The paper also evaluates alternative explanations for the easy financing of the U.S. current account deficit in recent years.

Abstract

The size and sources of international spillovers of activity remain subject to significant uncertainty. This Selected Issues paper uses a new approach to differentiating these effects using disturbances to a diverse group of small industrial countries as a proxy for global shocks. The results from the baseline vector autoregressions suggest that shocks to the United States are significant for foreign activity. The paper also evaluates alternative explanations for the easy financing of the U.S. current account deficit in recent years.

II. Summary of The Ties that Bind: Measuring International Bond Spillovers Using Inflation-Indexed Bond Yields

IMF Working Paper 07/128 by Tamim Bayoumi and Andrew Swiston

1. An implication of financial market globalization is the increasing likelihood of financial spillovers across countries. Rising internationalization of government bond holdings, in particular, is creating an increasingly interlinked and global market. As these yields also provide the “risk free” interest rate that is the basis for pricing in a wide swath of other markets, this provides an important economic link between countries.

2. The paper examines these links using data from inflation-indexed bonds. One limitation with previous work has been the difficulty in separating real bond yields from long-term inflation expectations. Fortunately, this decomposition has been facilitated by the development of inflation-indexed bonds, which allow these two components of nominal yields to be continuously tracked. With the U.S. inflation-indexed bond market now almost a decade old, there is sufficient information to allow statistical analysis of spillovers in real bond yields and inflation expectations.

3. Accordingly, the paper uses data from inflation-indexed government bond markets to examine international spillovers of real interest rates and inflation expectations. Using data since early 2002, it analyzes spillovers between the United States and six other industrial countries with inflation-indexed bond markets—Australia, Canada, France (a proxy for the euro area), Japan, Sweden, and the United Kingdom. This covers the vast majority of the industrial world (although for Japan, inflation-indexed bonds were only issued starting in 2004). The focus is on bilateral links between U.S. markets and other countries, reflecting the dominant position of the United States in the global bond market.

4. The paper first examines the direction of causation across markets using standard efficiency tests. In an efficient market, yields should follow a random walk, independent of past information on domestic or foreign yields. The importance of spillovers can thus be gauged by seeing how well past foreign yields explain current movements in bond yields.

5. Consistent with earlier research, the paper finds that U.S. markets have large spillovers abroad while there is limited reverse causation. Tests using a short sample of intraday data suggests that U.S. nominal yields produce significant spillovers in five of the six countries, with no evidence of reverse causation. Similarly, for a longer daily data set, spillovers from U.S. markets to real rates abroad are significant in four of six cases, again with no evidence of reverse causation. By contrast, the evidence for spillovers among inflation expectations suggests smaller (and more two-way) links.

6. The influence of U.S. yields on those in other countries can be quantified using a vector autoregression (VAR). Due to the predominance of spillovers from the United States to foreign markets, our base specification assigns any contemporaneous correlation between U.S. and foreign variables to the United States, although we also report an alternate specification in which U.S. inflation expectations are affected by contemporaneous events abroad. Impulse response functions from the VARs indicate that U.S. real interest rates and inflation expectations are extremely close to a random walk, while between one-quarter and one-half of U.S. real interest rate shocks are transmitted to foreign markets. Variance decompositions show that U.S. shocks account for about half of movements in foreign real rates over the long term (Table 1). Tests on weekly data confirm these results.

Table 1.

Variance Decompositions After 50 Days

(In percent; daily data from January 2, 2002 to December 29, 2006)

article image
Source: IMF staff calculations.

Alternate ordering for Australia and Japan is R*, P*, RUS, PUS.

Sample begins in April 2004.

Conclusions and Policy Implications

7. A relatively uniform picture emerges from this analysis:

  • Real interest rates appear much more linked across countries than the corresponding inflation expectations, just as expected given that real rates are more likely to be linked globally while expectations depend more on domestic events.

  • Real interest rate spillovers flow exclusively from the United States to other countries, and U.S. markets appear to absorb available information efficiently, in contrast to their foreign counterparts. Tests show that U.S. factors determine one-half or more of foreign real interest rates, on average.

  • There are smaller international spillovers in inflation expectations, with the results again suggesting that U.S. spillovers tend to be the most important but with more evidence of reverse causation. U.S. market developments account for a quarter to a third of fluctuations in foreign inflation expectations, while reverse spillovers generally account for a smaller proportion of U.S. forecasts.

8. In addition to confirming the dominant position of U.S. bond markets in global yields, these results illuminate the underlying sources of these links. In particular, it makes sense that U.S. markets are a major factor in determining global real rates, which should involve arbitrage across destinations, while inflation expectations—which are more domestically determined—are less integrated internationally and involve more complex dynamics. In addition, while U.S. developments are clearly crucial to global bond markets given the importance of its economy and financial markets, U.S. bond yields can and do also reflect international developments, such as the global “savings glut.” Deep and liquid U.S. bond markets are hence also central to global price discovery for long-term real rates.

9. These financial spillovers clearly represent an extremely important conduit from the United States to other industrial countries. This is particularly true as real interest rates are also a key driver of many other financial instruments, such as equities.

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