UC Santa Cruz

During the 2008 global financial crisis, several emerging market economy (EME) authorities argued that advanced economy policies including large-scale asset purchases by the U.S. Federal Reserve were primary sources of excessive capital flows and created adverse spillover effects to the EMEs. More recently, EME policy makers have been concerned about the adverse effects of advanced economy monetary policy normalization. Tracking the link between the monetary policy shocks in advanced countries and capital flows to emerging markets can be crucial for informing the debate about appropriate policy responses to capital inflows by the EMEs.

Many studies investigate the role of advanced economy policy measures as drivers

of capital flows between countries. However, the estimation of the relationship between

U.S. monetary policies and EME capital flows needs to account for anticipatory movements within the policy measures as well as endogeneity. That is why some of the recent literature, for example Miranda-Agrippino (2015), applies the Romer and Romer shocks (Romer and Romer (2004)) as a proxy for U.S. monetary shocks, to estimate the responses of global asset prices and international credit flows to US monetary policy. However, Coibion, et al (2016) recently found that the Romer and Romer proxy for U.S. monetary shock, does not influence important U.S. macroeconomic variables for sample periods starting from 1980.

To investigate this issue and get valid estimates for U.S. monetary shocks, this paper revisits the Federal Reserve’s information set which is created from observing the federal funds target rates set by the Federal Reserve around FOMC meetings. As a result, this paper derives a new measure for U.S. monetary shocks that adequately takes account of the Fed’s true information set at the time of FOMC meetings. In detail, this paper uses projected values for the CPI for periods when the PCE was not used by fed, then uses forecasts for the PCE for the rest of the sample period, instead of GDP deflator. Forecasts for foreign GDP and CPI indices are also used to take international endogenous and anticipatory movements into account in setting the Fed’s target rate.

The results show that using the new U.S. monetary shock measures reveals significantly

different effects in responses of U.S. domestic macroeconomic variables to monetary

shocks as well as in responses of some international financial variables, compared to results using the Romer and Romer shock. Specifically, a one percentage point increase in the new policy measure increases U.S. unemployment rate by 6 percent after one year, reduces GDP by 0.12 percent from its trend at the trough, and decreases the PPI by 35 percent at the lowest point. For international capital variables, a one percentage point rise in the U.S. policy shock increases cumulative net outflows of debt assets from Korea by over 10 billion dollars.