Saturday, April 12, 2008

Empirical Evidence on the Fed as a Monetary Hegemon

I recently made the following claim:
[The] Federal Reserve is a monetary hegemon. It holds the world's main reserve currency and many emerging markets are pegged to dollar. Thus, it's monetary policy is exported across the globe. This means that the ECB, even though the Euro officially floats, has to be mindful of U.S. monetary policy lest its currency becomes too expensive relative to the dollar and all the other currencies pegged to the dollar.
I suspect the most contentious part of this claim is the part where I said the ECB has to be mindful of the Fed's actions. I made a case for this view based on a figure that showed the path of the policy rates for the Fed and the ECB. Fortunately, I can now point you to more rigorous empirical work by John Taylor that supports my position:
...Many central bankers, even those with flexible exchange rate policies, watch the U.S. federal funds rate carefully when making policy decisions.

To illustrate this issue consider the relationship between Eurozone interest rates and U.S. interest rates during the past few years. Consider in particular the deviation of the overnight interest rate target for the European Central Bank from a simple guideline for that interest rate—the Taylor rule...

Now if one examines the relationship between this deviation and the actual federal funds rate in the United States during the period from 2000 through 2006, one finds a close empirical correlation between the two. An estimated linear relationship with the deviation on the left hand side has a coefficient on the federal funds rate of 0.21, which means that each percentage point reduction in the federal funds rate was associated with a 1/5 percentage point reduction in the ECB interest rate below what would otherwise be desirable on European price stability and output stability grounds... The relationship is highly significant statistically... For part of this period the ECB policy rate was below this guideline and according to these estimates a significant part of the deviation is “explained” by the U.S. federal funds rate being lower than normal.
You can read the rest here.

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