Heterogeneous effects in the international transmission of the US monetary policy: a factor-augmented VAR perspective

The FAVAR model introduced by Bernanke et al. (2005) is a coherent approach for examining the monetary policy transmission in the sense that it allow us to use a large number of economic and financial variables and based on this information, to obtain a reduced number of unobserved latent variables that drive the systematic components of an economy. Without loss of generality, we illustrate the FAVAR model, assuming a p-order lag.

Consider the information concerning the US and the RoW economies as summarized in the vector f_t = [f _t ^ROW , f _t ^US ]′ with K latent factors, extracted from a large panel of N macroeconomic indicators. Let the monetary policy instrument (i.e. the FFR) be the only observable indicator, denoted as R_t. The dynamics of the unobserved factors together with the observable factor are described in a standard finite p-order VAR model:where F_t = [f_t, R_t]′, f_t is the K × 1 vector of latent factors, R_t is the observable FFR, B_it is the K × K matrix of coefficients, and u_t is a vector of K idiosyncratic shocks with zero mean and variance–covariance matrix Ω_t. Following Cogley and Sargent (2005), the covariance matrix Ω_t in Eq. (1) is decomposed as A_tΩ_tA_t′ = Σ_tΣ_t′ with Σ_t = diag[σ_1t, …, σ_K+1,t], while A_t is a lower triangular matrix with its diagonal elements equal to one.

Next, the vector of informational time series X_t with dimension N × 1 is known to the central bankers. It is linked to the factors and the monetary policy tool by the following equation:where the factor loadings Λ _t ^f and Λ _t ^R are N × K and N × 1, respectively, and w_t is a N × 1 vector of error terms with zero mean and variance V_t defined as: V_t = diag[exp (v_1t), …, exp (v_Nt)].

We enrich our model by allowing the parameters (i.e. coefficients and error covariance matrix) to vary over time; thus, it can capture the time-varying effect of the shock on the economy. In contrast to relevant studies that break the sample between pre- and post-crisis periods (Boivin and Giannoni 2002, 2006), the time-varying FAVAR model (TVP-FAVAR hereafter) allow us to examine the changing international transmission of the US policy shock for every point in time.³ The time-varying parameters B_it, A_t, V_t are assumed to be evolved as random walk while the elements of Σ_t evolve as a geometric random walk. In particular, as concerns the observation equation given by (2), the diagonal elements of the covariance matrix V_t evolve as:For the VAR model given by (1), the parameters evolve as:We assume that all innovations are normally distributed with the following assumptions on the variance–covariance matrix:where I_K is a K dimensional identity matrix and Q, S, W are positive definite matrices.

We estimate the factors and the associated loadings from Eq. (2), by using PCA varimax rotation analysis (Bernanke et al. 2005; Boivin et al. 2013) separately for the US and RoW economies. Our analysis indicates the need to include four international and four US domestic factors.⁴ The first three factors capture the effects of real activity, inflation and asset prices correspondingly. We add a fourth factor that captures the effect of trade variables. The international factors are identified through the upper N × K₁ block of the matrix Λ^f, while the dynamics of the US domestic factors are identified through the bottom N × K₂ block of the Λ^f (Mumtaz and Surico 2009).

The US policy shock in Eq. (1) is identified as the only shock that does not contemporaneously affect the other series. Since all US variables are likely to respond more instantly to monetary policy innovations within the quarter, the contemporaneous relationship between the FFR and the variables must be removed. To address this, we first divide the number of US variables into two groups: the slow-moving and the fast-moving variables, depending on how fast they respond to the US policy shock. As Bernanke et al. (2005) point out, the fast-moving variables (financial indicators and asset prices) are those variables that are assumed to be contemporaneously responsive and sensitive to policy shocks, while the slow-moving variables are those that are assumed to be contemporaneously unresponsive to policy shocks. The US slow-moving factors (denoted as f^US,slow) are extracted by PCA of the US slow-moving variables. Next, we extract the US domestic K₂ + 1 principal components from all the US variables into X_t. Finally, following Mumtaz and Surico (2009), we estimate a regression of the form:where C(f _t ^US,slow , R_t) represents the common space spanned by the K₂ + 1 principal components of the US domestic variables, \( \tilde{C}\left( {f_{t}^{\text{US,slow}} } \right) \) are obtained by extracting principal components from the subset of the slow-moving variables that are not affected contemporaneously by R_t; and θ_t, is the error term. The estimated factors \( \hat{f}_{t}^{\text{US,slow}} \) are taken as the difference: \( \hat{C}\left( {f_{t}^{\text{US}} ,R_{t} } \right) - b_{2} R_{t} \). Thus, the identification of the US policy shock is achieved by recursively ordering: \( f_{t}^{w} ,\hat{C}\left( {f_{t}^{\text{US}} ,R_{t} } \right) - b_{2} R_{t} \), with R_t being the last element in Eq. (1). The ordering assumed here imposes that both international and domestic US unobserved factors do not respond to monetary policy innovations within the quarter.

We estimate the model by using Bayesian techniques. In particular, the model is estimated using a Gibbs sampler algorithm to obtain the posterior distributions of our parameters. We use 20,000 iterations discarding the first 16,000 as burn in. A description of the prior and posterior distributions is provided in “Appendix”. Impulse responses are estimated by writing the structural form of the VAR Eq. (1), as:with the structural errors being equal to: u_t = A _t ⁻¹ Σ_tn_t. The matrix A _t ⁻¹ captures the contemporaneous relations of the shocks and n_t is the error term with zero mean and the identified covariance matrix. We extract the structural shocks n_t given the posteriors of B_t and Ω_t at each point in time and also, the Cholesky decomposition of the covariance matrix Ω_t, by setting Ω_t = PP′ where P = A _t ⁻¹ Σ_t.

We start the empirical analysis by setting the effect of the policy shock in the US economy itself. The first policy question that arises is whether the propagation of a US policy shock exerts its influence in the US economy through the transmission channels. Figure 1 illustrates the estimated effects of a US policy shock on its sovereign variables within a horizon of fifteen quarters ahead (h = 15). We draw some interesting findings from these results by comparing the behaviour of the impulse responses (IRFs) under a contractionary policy shock.

As Fig. 1 demonstrates, the responses for the majority of the variables are consistent with the theoretical predictions formulated in the relative literature. In particular, we observe that output decreases gradually, inflation prices go down and monetary aggregates decline. The negative correlation between nominal interest rates and inflation suggests that our model properly manages to deal with the price puzzle observed in small-scale VAR models. Similarly, the negative relationship between interest rates and the money stock reveals that the liquidity effect observed elsewhere in the VAR literature is absent. In terms of transmission channels, the effect on the trade balance and the fall observed in imports and exports denote the functional efficiency of the MFD model and the channel described under the Redux model, respectively. In the same manner, the fall in stock prices and consumer credit reveals the importance of the balance sheet channel. Finally, the results indicate that the exchange rate and forward discount puzzle under Dornbusch’s overshooting hypothesis is not present in the FAVAR model, since the shock leads to an initial depreciation for all foreign exchange rates and a gradual appreciation afterwards.¹²

We turn next to the analysis of impulse responses to a positive US policy shock during the global integration and the US financial crisis in 2007. We draw the importance of the findings by comparing the magnitude and the sign of the impulse responses estimates. Table 2 depicts the posterior medians of impulse responses four quarters ahead. The global integration is examined from 1987 to 1999, since this period gauges the impacts of the deepening of globalization. The pre-and post-US financial crisis periods are considered with the break year 2007 as denoted in Sect. 3. A point estimate close to zero that is associated with a variable in Table 2 implies a weak significant effect of the US policy shock.

As Table 2 shows, the effects of the US policy shock on the majority of the variables are bigger in 1999 compared to 1987. Taking into account some sovereign contextual factors (e.g. the magnitude of domestic changes or the efficiency of the transmission mechanisms involved), the resulting behaviour of the variables is consistent with the period of global integration which justifies the lower perceived volatility of domestic imbalances, higher liquidity and credit accessibility, and reduction of liquidity constraints among others. Regarding the pre-and post-crisis period, the variables that cover the real activity, inflation and asset prices, are positive before the outbreak of the crisis and are highly negative in its aftermath; what is more, the effect is stronger for real activity and inflation variables in the post-crisis period compared to the pre-crisis period. In summary, the results reveal a more intense effect of the shock on core macroeconomic variables and show a worsened condition of the US economy, which justifies the implementation of unconventional policies taken by US policymakers.

To further investigate the evolution of monetary policy, this subsection discusses the implications arising from the transmission of a US policy shock to the SEA and the EU economies. The impulse responses that generate the transmission mechanism of the US policy shock to SEA can be seen in Figs. 2, 3 and 4.

Before we move on to the description of the four transmission channels, we analyse the impact of the shock on two core macroeconomic indicators, GDP and unemployment. As shown in Fig. 2, a US policy shock lowers GDP after a short initial increase observed in Hong Kong, Philippines, China and Singapore, while the responses for South Korea and Japan are insignificant. A more careful inspection of Fig. 2 reveals that GDP responses of consumption, investment and employment show an initial hike in response to the shock, which later either dies out or becomes negative. This implies that the initial increase in output and the subsequent decrease are driven by consumption, investment and employment. Concerning labour markets, we notice that immediately after the shock there is an increase in unemployment in all countries in this region, which dies out after 2–3 months.

To dig further into the dynamics that move consumption, investment, employment and therefore, output, we should explore the role played by the trade balance in the region. Figure 3 shows that there is an immediate hike in trade balance in almost all SEA economies following the shock, which then becomes negative. This finding explains why we observe these behaviours in the macroeconomic variables. In particular, it seems that the expenditure switching effect, which is indicated by the small, initial improvement of the foreign trade balances, dominates in the first 2 months; this is why we observe these hikes in consumption, investment and employment. After that point, the income absorption effect dominates the system, particularly for China, Singapore and the Philippines, as indicated by the strong and significant worsening of their trade balances, which justifies the fall in output.

Our results are in line with former empirical studies that found the income absorption effect to be more important than the expenditure switching effect in the international transmission of monetary policy shocks (Jannsen and Klein 2011). In terms of trade balance, there is an interesting difference between Kim’s (2001) results for non-US G-7 countries and this paper’s results. In particular, Kim finds that changes in foreign trade balance as a response to the US shock seem to play a minor role. This view accords well with the idea that emerging markets are more vulnerable to external shocks than are large and developed economies. Our findings are consistent with Canova (2005), who estimates the effects of US monetary policy shocks on emerging markets in Latin America and finds that, a US monetary policy shock does have an important effect in foreign trade balance.

Continuing with our analysis, we explore the role of wealth effects in the international transmission mechanism. Figure 3 points out the importance of this transmission channel for the majority of SEA countries (except China and Japan, for which a minor effect is observed). The reason is that there is significant depreciation in bilateral exchange rates and real effective exchange rates, followed by increases in inflation prices in these countries. Our results are consistent with Mackowiak (2007) who finds that US monetary policy shocks affect the exchange rate in a typical emerging market quickly and strongly and that the price level in emerging markets responds to US policy shocks by more than the price level in the USA itself.

Next, we investigate the importance of the channel under the Redux model as. Our empirical findings support the existence of this channel in the transmission mechanism. In particular, the results in Fig. 3 show that after an initial short rise in imports and exports, a strong and significant decrease follows in both variables as a result of the US monetary tightening. This final reduction in imports and exports in foreign economies may be due to the fact that residents in SEA economies decrease their demand for domestic and foreign goods and services, as evidenced by decreases in the responses of consumption for most of the these economies (Fig. 2).

Finally, Fig. 4 reports evidence in favour of the effectiveness of the balance sheet channel by revealing two main findings. The first one is that equity prices decline in all SEA countries. The second one is that there is a significant reduction in the responses of stock markets, consumer credit and/or bank lending in all SEA countries, except for South Korea, suggesting that the SEA consumers’ access to credit is diminished as a result of the US monetary policy shock. In the case of South Korea, one possible explanation can be that the domestic banking sector of balance sheet activities (e.g. operating leases) insulates their loan supply against monetary policy shocks, thus creating a buffering effect on monetary transmission. Overall, the latter finding is consistent with the international credit channel recently discussed by Rey (2016), under which, a US contractionary monetary policy shock tightens credit conditions abroad. We provide empirical evidence that this channel does work for SEA economies.

Last, we assess the transmission of the US monetary policy in relation to the exchange rate regimes in the SEA economies. We would expect that a contractionary US monetary policy shock would depreciate the exchange rate of SEA currencies against the US dollar when a flexible exchange rate regime is allowed. However, Fig. 1 reveals that based on the error bands, the exchange rate depreciation in the short run is not significant for all countries, except for Korea. In particular, for China and Hong Kong, exchange rate movements are only significant on the medium and long horizon, while in Korea, there is a significant depreciation immediately after the shock.

The responses of the exchanges rates are quite interesting, given the exchange rate regimes that apply to these economies. In particular, the interest rates of the Philippines and Singapore, two countries that allow some exchange rate flexibility, exhibit a significant initial increase as a response to US policy rate increases, which can fully nullify the effects of the contractionary US monetary policy shock. The same behaviour is observed for Hong Kong, a country that adopted a fixed exchange rate regime. One can notice that interest rate reacts positively immediately after the shock to contribute to the exchange rate stability in response to the US monetary tightening. On the other hand, the insignificant response of the interest rate in Korea (a country with a relatively flexible exchange regime) shows that the Bank of Korea does not respond very much to the US interest rate changes. As a result, significant exchange rate depreciation is found in Korea. These results indicate that the conventional exchange rate channel is unlikely to play much role in the transmission of a US interest rate hike to the SEA economies, excluding Korea, in the short run.

Figures 5, 6 and 7 show the responses of the EU economies under a US policy shock. A monetary tightening leads to a hike in economic activity (i.e. real GDP and industrial production indices) as shown in Fig. 5.

One possible explanation for this might be the role of exchange rates. Combining these results with the responses from the bilateral exchange rates shown in Fig. 1, we argue that the depreciation of both currencies (euro and pound) against the dollar may provide a good explanation for the rise observed in foreign output in the EU countries. Indeed, the importance of the exchange rate mechanism in raising the output in the EU as a result of the US monetary tightening is further enhanced by the fact that there is an initial short depreciation in the real effective exchange rates in all EU countries, as shown in Fig. 6. The responses of trade balance are both positive and insignificant (UK and Spain), or, they have the opposite signs of what would be expected under the MFD model. Taken together with the results, we conclude that the initial rise observed in economic activity in EU as a result of the shock is more driven by exchange rate changes rather than movements in the trade balance. These findings are in accordance with Kim (2001), who finds that the effect of US monetary policy on the foreign balance of developed economies is negligible.

Within this context, another interesting finding is the fact that the rise in foreign output produces a significant reduction in unemployment for all the countries, except for Germany. One possible explanation might be that the German economy has vast financial resources and high industrial production, allowing it to boost its output without necessarily showing significant reduction in unemployment. This can be explained by the high level of technology, new international trade partners or new investment opportunities.

Next, the transmission via wealth effects does play a significant role in the region. In particular, the effective exchange rates for most EU economies depreciate immediately after the shock, while the subsequent increase observed is insignificant. In addition, following the US monetary policy shock, inflation rises in all EU economies. Our findings are consistent with Neri and Nobili (2010) who find that an increase in the FFR causes the euro to immediately depreciate.

The transmission channel under the Redux model seems to be working via exports; since in response to the shock, exports fall for all countries after an initial short increase. The same is not true for imports. The responses show that imports fall (following an initial short increase), with the exception of Germany, France and Italy, where imports rise in the first four quarters and then smoothly fade out. For these countries, the initial appreciation of the euro increases the purchasing power and private consumption of their residents (as shown in Figs. 1, 5) and in turn, may increase the imports from the domestic supply side (companies and micro-foundations) for foreign goods and services, functioning as a dynamic model of utility maximization.

Last, in contrast to SEA economies for which the balance sheet channel is found to have a pronounced impact, the results indicate that there is no strong evidence in favour of the existence of this channel in EU. In particular, although the consumer credit response for Germany is negative, it is insignificant. The effect on consumer credit variables for the other eurozone countries and the UK, although positive, is just on the verge of being insignificant; therefore no strong conclusions can be drawn from these responses.

In this section, we examine how has the international monetary transmission mechanism evolved over time. Tables 3, 4 and 5 depict the posterior medians of impulse responses four quarters ahead. Table 3 depicts the effect of the policy shock on real activity and inflation variables, while Tables 4 and 5 illustrate the effect of the shock on trade variables and asset prices, respectively.

The findings are quite interesting when we compare the magnitude of these estimates for the EU and the SEA economies. The transmission mechanism of the policy shock shows a great heterogeneity during the global integration period. The results show that the deepening of global integration dampens the effect of the shock to the foreign economies in core macroeconomic and financial variables, e.g. GDP, industrial production, private consumption, investment, short-term rates and stock market. In contrast, globalization has increased the effect of the US policy shock to trade variables in foreign economies. This finding is as expected since the deepening of global integration resulted in the world network of the markets as an outcome of the increased trade exchange. In the period from 2007 to 2014, the magnitude of the effect on real activity variables (GDP, industrial production, consumption and investment) is far lower than in the period from 1987 to 1999. It implies that the effect of a US policy shock on core foreign macroeconomic variables has diminished through time as a result of globalization. The change can be justified either by the decline in the role of the US as an international financial hub with the emergence of other large foreign economies through the years, and/or by the regime switches of domestic monetary and nominal exchange rate policies in the foreign countries. In the latter case, during the last two decades, the majority of advanced countries in the EU have adopted inflation targeting policies to stabilize inflation expectations, while some SEA countries have adopted both inflation targeting policies and float nominal exchange rate regimes, particularly after the South East Asian crisis in 1997. Due to the fact that the US policy shocks are sources of variations in terms of prices and exchange rates for all the world economies, the endogenous policy responses to these variations affect the magnitude of the transmission of the US policy shocks to the domestic economic activities in its counterparts.

Next, we find strong evidence that the magnitude of the effect of the shock is different in the pre- and post-US financial crisis period. The effect of the shock on the majority of the variables (GDP, inflation, unemployment, exchange rates, stock prices and consumer credit) has increased in the post-2007 period. The findings provide a novel insight herein, suggesting that in the aftermath of the financial crisis, both macroeconomic and financial variables are strongly reacting to policy changes originated in the USA. On the other hand, the magnitude of the transmission of the shock for a small number of variables, e.g. imports and exports, has decreased. The latter effect may be due to the fact that the financial crisis produced a severe worldwide drop in demand, which resulted in what Baldwin (2009) refers as the great trade collapse. In summary, the strong impact of the US monetary tightening in the EU and SEA suggests that in times of crisis, foreign central banks should follow a credible monetary policy in response to the US monetary policy shock in order to stabilize possible fluctuations in output and mitigate the negative effects in many other economic sectors.

Last, we wonder ourselves whether the FED still has the ability to majorly affect the global economy. In other words, has the monetary policy of RoW economies changed in such a way that they are able to efficiently insulate themselves from a US monetary policy shock? We investigate this issue by examining if foreign policy endogeneity is present in the SEA and EU countries. We observe that in response to rises in output, short-term rates (as denoted in Figs. 4, 7) increase in all countries (with the exception of South Korea). Moreover, we notice a significant reduction in the monetary aggregates, which further confirms the hypothesis that short-term rates in the EU respond endogenously to US monetary tightening. From a policymaking perspective, this means that the ECB and the Bank of England will respond to a US monetary tightening by increasing short-term rates in order to cool economy boost and inflationary pressures caused by the US policy. Indeed, the GDP responses in the long term (after the 4th horizon ahead) show that the initial increase in the level of economic activity has faded, which is the result of the policymaking intervention. In the case of SEA, the increases in central banks’ interest rates are likely to nullify the effects of US policy shocks on the currencies’ depreciation (as shown in Fig. 1). This can contribute to exchange rate stability and mitigate inflation in response to US monetary tightening, which further supports our hypothesis.