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The Impact of U.S. Monetary Policy Normalization on Capital Flows to Emerging-Market Economies

Tatjana Dahlhaus and Garima Vasishtha

Staff Working Papers from Bank of Canada

Abstract: The Federal Reserve’s path for withdrawal of monetary stimulus and eventually increasing interest rates could have substantial repercussions for capital flows to emerging-market economies (EMEs). This paper examines the potential impact of U.S. monetary policy normalization on portfolio flows to major EMEs by using a vector autoregressive model that explicitly accounts for market expectations of future monetary policy. The “policy normalization shock” is defined as a shock that increases both the yield spread of U.S. long-term bonds and monetary policy expectations while leaving the policy rate per se unchanged. Results indicate that the impact of this shock on portfolio flows as a share of GDP is expected to be economically small. The estimated impact is closely in line with that seen during the end-May to August 2013 episode in response to a comparable rise in the yield spread of U.S. long-term bonds. However, as the events during the summer of 2013 have shown, relatively small changes in portfolio flows can be associated with significant financial turmoil in EMEs. Further, there is also a strong association between the countries that are identified by our model as being the most affected and the ones that saw greater outflows of portfolio capital over May to September 2013.

Keywords: International topics; Transmission of monetary policy (search for similar items in EconPapers)
JEL-codes: C32 E52 F33 F42 (search for similar items in EconPapers)
Pages: 28 pages
Date: 2014
New Economics Papers: this item is included in nep-cba, nep-mac, nep-mon and nep-opm
References: View references in EconPapers View complete reference list from CitEc
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Persistent link: https://EconPapers.repec.org/RePEc:bca:bocawp:14-53

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