The Federal Reserve, Emerging Markets, and Capital Controls

Changes in Federal Reserve policy on interest rates over the last decade have affected domestic short-term interest rates in seven emerging economies.

In The Federal Reserve, Emerging Markets, and Capital Controls: A High Frequency Empirical Investigation (NBER Working Paper No. 18557) Sebastian Edwards concludes that changes in Federal Reserve policy on interest rates over the last decade have affected domestic short-term interest rates in seven emerging economies in Latin America and Asia. The extent of transmission of interest rate shocks differs across the various countries. Edwards also finds that capital controls are not an effective tool for isolating emerging countries from global interest rate disturbances.

All of the countries that Edwards studies -- Brazil, Chile, Colombia, Mexico, Indonesia, Korea, and the Philippines -- had flexible exchange rates during the period he analyzes, and they followed some kind of inflation targeting. These countries also had different degrees of capital mobility during the first decade of the 2000s. On a scale from 1 to 10, where 10 denotes unrestricted mobility of capital, capital mobility ranged from a high of 8.4 in Chile in early 2008 to a low of 2.9 in Colombia in 2002.

For this study, Edwards analyzes weekly data -- most previous analyses have relied on either monthly or quarterly data. He studies only countries with flexible exchange rates, which has become increasingly common among emerging economies. He also uses a new index of capital mobility to analyze whether controls on financial flows affect the transmission of interest rates shocks, and he pays particular attention to the short-run dynamics of interest rate adjustments to global financial disturbances. Moreover, Edwards concentrates on the role of the steepness of the U.S. yield curve in explaining the international transmission of interest rates, and especially to how a policy aimed at "twisting" the yield curve -- as announced by the Fed's Federal Open Market Committee on September 21, 2011 -- may affect local interest rates.

He concludes that in the three Asian countries in the sample, Fed actions tend to be fully transmitted into interest rates, while in the Latin American countries, about one half of the U.S. interest rate change passes through to local interest rates. The adjustment process is also significantly faster in Asia than in Latin America. Edwards also finds that capital controls are not an effective tool for isolating emerging countries from global interest rate disturbances in the medium and longer run. Indeed, his analysis indicates that domestic interest rates in countries with a lower degree of international mobility of capital have been somewhat more sensitive to Fed policy shocks than interest rates in nations that are more integrated into the world capital market.

--Matt Nesvisky