ECB and U.S Monetary Policy Spillovers to Sweden: Transmissions Channels and the Effects of Central Bank Information Bias/ Unconventional Monetary Policy
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Department of Economics Spring 2021 Master's Thesis Work, 30.0 HP ECB and U.S Monetary Policy Spillovers to Sweden: Transmissions Channels and the Effects of Central Bank Information Bias/ Unconventional Monetary Policy Author: Ludvig Mannerson Supervisor: Spyridon Sichlimiris 1 Abstract This paper revisits the transmission of ECB and U.S Fed monetary policy to Sweden by using recently developed measures of ECB and Fed monetary policy shocks, corrected for the central bank information element. To analyze the spillovers of foreign monetary policy to Sweden I rely on the Local Projections methodology. First, I show that standard measures of foreign monetary policy shocks that are known to contain a central bank information element can cause counterintuitive spillover effects to Swedish macroeconomic and financial variables. Second, my results suggest that monetary policy spillovers from the ECB and U.S Fed both have substantial impact on the Swedish economy, particularly through the aggregate demand channel. While an ECB monetary contraction has a strong negative impact on Swedish macroeconomic variables, the tightening of the U.S Fed monetary policy mostly exhibits an expansionary effect. Lastly, but crucially, my thesis demonstrates that US monetary policy has more substantial spillovers during the conventional monetary policy period, as the aggregate demand channel is muted during periods of unconventional monetary policy. Acknowledgements I would like to thank Spyridon Sichlimiris for his valuable time, comments, suggestions, and proof-reading. Spyridon has been a fantastic supervisor and this thesis would not have been possible without our numerous discussions regarding everything from topic selection to methodology application. His quick email replies and availability for our “short notice” meetings has been much appreciated. Thank you! 2 Table of contents 1: Introduction ............................................................................................................................ 4 2: Theory ..................................................................................................................................... 7 2.1 The Exchange Rate Channel ...................................................................................................... 7 2.2 The Aggregate Demand Channel ............................................................................................... 8 2.3 The Financial Channel ................................................................................................................ 9 3: Previous Empirical Research ................................................................................................ 11 3.1 Monetary Policy Spillovers, the Bias of Information Shocks ................................................ 14 3.2 Contribution of My Thesis to the Monetary Policy Spillover`s Literature .......................... 16 4: Data of ECB and U.S Fed Monetary Policy ........................................................................... 16 4.1 Swedish Economic and Financial Variables ........................................................................... 18 5: Methodology to Study the Effects of Spillovers ..................................................................... 19 6: Results................................................................................................................................... 21 6.1: Spillovers Effects from ECB Monetary Policy Shocks Vs ECB Information Shocks to Macroeconomic Variables .............................................................................................................. 21 6.1.2 Spillovers to Financial Variables .......................................................................................... 26 6.2 Spillovers Effects from ECB Monetary Policy Shocks Vs U.S Fed Monetary Policy Shocks 29 6.2.1 Spillovers to Macroeconomic Variables ............................................................................... 29 6.2.2 Spillovers to Financial Variables .......................................................................................... 33 6.3 Spillovers Effects from U.S Conventional Vs Unconventional Monetary Policy Shocks ....... 35 7.1: Sensitivity Analysis ............................................................................................................. 38 7.2 Robustness Test Using Different Construction Methods of US Monetary Policy Shocks .. 41 8: Conclusion ............................................................................................................................ 44 3 1: Introduction The economic and financial crises of the past two decades and the increasing reliance on unconventional monetary policy measures has contributed to rekindle the debate regarding the impact of international monetary policy spillovers. In an influential “pre-crisis” paper published by Obstfeld and Rogoff (2002), the authors argued that the cross-border effects of domestic monetary policy spillovers were likely to be negligible, even in a fully economically integrated world. Because of this, the authors further argued that any international coordination of monetary policy would be redundant, and that domestic monetary policies should only focus on domestic objectives. However, evidence from the past decades have demonstrated the possibility for foreign monetary policy shocks to transfer across borders though different transmission channels, and strongly affect economic and financial conditions in other nations (Hajek and Horvath, 2017; Saskia et al, 2018). Consequently, the effects of foreign monetary policy spillovers have become critically important to for central banks and economic researchers to consider. Understanding how foreign monetary policy can affect the domestic economy is quickly becoming more important in a rapidly globalizing world. As individual countries have become more integrated through the ever-expanding trade of goods, services, capital, and technology, they have also become more vulnerable to foreign financial and economic conditions that propagate through these transmission channels, such as foreign monetary policy stances (Bräuning and Sheremirov, 2019, Ca' Zorzi et al., 2020, Ehrmann and Fratzscher, 2009; Ehrmann et al., 2011; Hale et al., 2016, Jarocinski and Karadi, 2018). It has also been proposed that growth and financial conditions worldwide are to some extent determined by a global financial cycle, which is largely determined by U.S monetary policy (Rey, 2013; Bekaert et al., 2013). The large increase in worldwide economic integration in addition to the extensive policy of monetary expansion has consequently contributed to renewed interest regarding the impact of foreign monetary policy spillovers (Ca' Zorzi et al., 2020). For example, a large strain of previous research has in aggregate found that economies are subject to experience substantial economic consequences due to monetary policy spillovers, particularly from larger entities such as the European Central Bank or the U.S Federal Reserve (Hajek and Horvath, 2017; Ca' Zorzi et al., 2020; Gertler & Karadi 2015; Georgias, 2016). However, previous literature has mainly focused on monetary policy spillovers form one single central bank, and few papers have 4 attempted to make any comparisons between spillovers emanating from different central banks in a unified framework. This is of crucial importance, as monetary policy spillovers emanating from different central banks could propagate though different transmission channels and exhibit heterogeneous effects on the economies that they impact. Therefore, the purpose of this thesis is to contribute with a better understanding of the different effects and transmissions channels between monetary policy spillovers deriving from the ECB and U.S Fed on the small open economy of Sweden. By analyzing the response of a wide variety of Swedish economic and financial variables, the strength of the different monetary policy spillovers and the transmission channels through which they propagate, can better be established. Sweden is chosen as the country of analysis because of its openness to trade, floating exchange rate, and tight integration with the European Union. Furthermore, previous research by Hajek and Horvath (2017) found that Sweden exhibited some of the most potent responses to foreign monetary shocks out of all the countries analyzed in his dataset. The timeframe selected for this analysis goes from January 1999, when the ECB assumed responsibility for Euro-area monetary policy (ECB, 2021), to May 2019. All data for this analysis has been acquired at monthly frequency, which allows for investigation of the foreign monetary policy spillover effects to the Swedish economy at a relatively high frequency. Lastly, the choice to compare the effects of ECB monetary policy spillovers to spillovers from the U.S Fed is because U.S. monetary policy is often recognized, due to its size and the role of its dominant currency, as a principal driver of global business cycles (Rey, 2013; Bekaert et al., 2013). Regarding the estimates of foreign monetary policy, recently published research by Nakumura and Steinsson (2018) and Bu et al (2020) show that previous monetary policy estimates contain a “central bank information effect”, which contributes to estimation biases, particularly for ECB monetary policy (Jarocinski, 2020). The central bank information effect can best be described as the ability of central banks to affect market expectations and