Monetary Independence in a Financially Integrated World: What Do Measures of Interest Rate Co-Movement Tell Us?

Abstract

Does global financial integration reduce the independence of monetary policy or its effectiveness? Do flexible exchange rates offer sufficient insulation from foreign monetary and financial developments? To provide an answer to these questions, this paper summarises the outcome of ongoing research conducted at the BIS on the measurement of co-movements in short- and long-term interest rates across countries. The sensitivities of domestic short-term interest rates to their foreign counterparts are found to be increasing in financial openness and exchange rate stability, as predicted by Mundell’s trilemma hypothesis. By contrast, long-term yield sensitivities are increasing in financial openness, but their relationship with exchange rate stability is non-monotonic. Excluding pegged exchange rates or very stable currencies, which display a high degree of sensitivity, the relationship for other currencies is negative: that is, a more volatile exchange rate is associated with larger long-term interest rate spillovers from core countries. Estimates of domestic short-to long-run interest rate pass-through also show that greater exchange rate flexibility does not necessarily translate into stronger control of the long end of the yield curve.

Full Publication: Expanding the Boundaries of Monetary Policy in Asia and the Pacific

Keywords: Mundell’s trilemma, international monetary and financial system, government bond yields, interest rate spillovers, interest rate pass-through

JEL Classification: E52, F42, G15, O57