COVID-19 and Exchange Rates: Spillover Effects of U.S. Monetary Policy

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COVID-19 and Exchange Rates: Spillover Effects of U.S. Monetary Policy

One sentence summary: The spillover effects of U.S. monetary policy have been effective only for certain countries that can be explained by the disease outbreak channel.

The corresponding academic paper by Hakan Yilmazkuday has been accepted for publication at Atlantic Economic Journal.

The working paper version is available here.

 
Abstract
This paper investigates the spillover effects of U.S. monetary policy on exchange rates of 11 emerging markets and 12 advanced economies during the pre-COVID-19 versus COVID-19 periods. The investigation is achieved by a structural vector autoregression model, where year-on-year changes in weekly measures of economic activity, exchange rates and policy rates are used. The empirical results suggest evidence for the spillover effects of U.S. monetary policy for several countries during the pre-COVID-19 period, whereas they have been effective only for certain countries during the COVID-19 period that can be explained by the disease outbreak channel. Important policy implications follow.

 

Non-technical Summary

The Coronavirus Disease 2019 (COVID-19) has reduced economic activity in an unprecedented way. This reduction has resulted in extraordinary unemployment levels around the world. Accordingly, several central banks, including the U.S. Federal Reserve System, have reacted to the economic developments due to COVID-19 by reducing their policy rates.

This paper investigates the spillover effects of U.S. monetary policy on exchange rates during the pre-COVID-19 versus COVID-19 periods. The main objective is to investigate whether these spillover effects have been effective during the COVID-19 period. Country-specific analyses are conducted for 11 emerging markets and 12 advanced economies, where monetary policies of these countries are also controlled for. The formal investigation is by a structural vector autoregression (SVAR) model, where year-on-year growth rates of weekly measures of economic activity, exchange rates, and policy rates are used during the pre-COVID-19 versus COVID-19 periods.

The spillover effects of U.S. monetary policy are investigated by accepting the U.S. economy as an exogenous block to be used in the SVAR estimation of each country. We focus on the cumulative impulse response of exchange rates (constructed as appreciation of currencies) to a negative shock on the (shadow) federal funds rate. We also investigate the contribution of (shadow) federal funds rate to the exchange rate volatility of domestic currencies based on the forecast error variance decomposition.
 

The empirical results suggest that there is evidence for the spillover effects of U.S. monetary policy for almost all countries during the during the pre-COVID-19 period, whereas they have been effective for only certain countries during the COVID-19 period. When we further investigate the reasons behind the heterogeneity across countries, we show that only the exchange rates of countries that were successful in fighting against COVID-19 were subject to the spillover effects of U.S. monetary policy during the COVID-19 period

 

 

The corresponding academic paper by Hakan Yilmazkuday has been accepted for publication at Atlantic Economic Journal.

The working paper version is available here.

COVID-19 and Monetary Policy with Zero Bounds: A Cross-Country Investigation

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COVID-19 and Monetary Policy with Zero Bounds: A Cross-Country Investigation

One sentence summary: Emerging markets or countries without a zero bound on their interest rates were able to reduce their interest rates as a reaction to reduced economic activity and to the volatility in their exchange rates, whereas advanced economies or countries with a zero bound on their interest rates were not.

The corresponding academic paper by Hakan Yilmazkuday has been accepted for publication at Finance Research Letters.

 

The working paper version is here.

 
Abstract
Using daily data on policy rates from 28 advanced economies and 32 emerging markets, this paper investigates the monetary policy reaction function of central banks during the Coronavirus Disease 2019 (COVID-19). Since inflation is mostly silent during this period, the reaction function focuses on the changes in economic activity measured by daily Google mobility data and the depreciation rate of currencies. The panel estimation takes the question of causality seriously by using a difference-in-difference approach with weekly changes in variables, where time fixed effects, country fixed effects as well as the country-specific effects of the 100th COVID-19 case in each country are controlled for. The results show that emerging markets or countries without a zero bound on their interest rates were able to reduce their interest rates as a reaction to reduced economic activity and to the volatility in their exchange rates, whereas advanced economies or countries with a zero bound on their interest rates were not. Several policy implications follow for countries with a zero lower bound on their interest rates amid COVID-19.

Non-technical Summary

Several governments have issued stay-at-home orders around the world to fight against the Coronavirus disease 2019 (COVID-19) pandemic. Even essential sectors (e.g., food production) have experienced shutdowns due to workers diagnosed with COVID-19, because COVID-19 spreads mainly through person-to-person contact. These developments have created unprecedented unemployment rates around the world. Accordingly, several central banks have reacted by changing their policy rates to help their economies.

This paper investigates the monetary policy reaction function of central banks for 28 advanced economies and 32 emerging markets during the COVID-19 pandemic covering the daily period between February 15th, 2020 and May 2nd, 2020. Since inflation is mostly silent during this period, the reaction function focuses on the changes in economic activity measured by daily Google mobility data and the depreciation rate of currencies. A panel estimation is achieved by taking the question of causality seriously, where a difference-in-difference approach is used with weekly changes in variables. In this panel estimation, time fixed effects, country fixed effects as well as the country-specific effects of the 100th COVID-19 case in each country are all controlled for.

The variables are summarized below for advanced economies versus emerging markets.

Similarly, they are summarized below for countries with and without zero bounds on their interest rates, where countries with zero bound on interest rates are defined as those that have a policy rate below 0.5% as of May 2nd, 2020 (although a continuous measure through threshold interest rates is used in formal estimations).

As is evident, although the reduction in economic activity starting from March 2020 is very similar across country groups, the policy rate changes and depreciation rates are highly different. This suggests that alternative country groups might have reacted differently to the reduction in their economic activity.

Due to the significantly positive coefficients in monetary policy reaction functions, given that economic activity is reduced during the sample period, the panel empirical results based on the pooled sample suggest that central banks have reacted by reducing their policy rates. The panel empirical results also suggest that central banks have reacted to sustain the stability of their currencies, potentially to keep future inflation under control.

In additional analyses, countries have been categorized as advanced economies versus emerging markets as well as those with and without zero bounds on their interest rates. The corresponding panel estimation results show that emerging markets or countries without a zero bound on their interest rates were able to reduce their interest rates as a reaction to reduced economic activity and to the volatility in their exchange rates, whereas advanced economies or countries with a zero bound on their interest rates were not.

 

Several policy implications follow for countries with a zero lower bound on their interest rates during COVID-19. These include considering alternative policies such as unconventional monetary or fiscal policies as they have been shown to work better for countries with a zero lower bound on their interest rates. However, as the ability of these countries to conduct fiscal is limited by their access to credit markets, countries should pay more attention to their credit rating if they would like to be successful in fighting against the economic implications of COVID-19.

The corresponding academic paper by Hakan Yilmazkuday has been accepted for publication at Finance Research Letters.

 

The working paper version is here.