Monetary policy response in emerging market economies: why was it different this time? by Ana Aguilar and Carlos Cantú published by BIS (11/2020)
“The playbook of emerging market economy (EME) central banks facing a financial crisis calls for them to tighten monetary policy sharply in order to stem massive capital outflows and a sharp currency depreciation. Monetary policy is then procyclical. It is tighter precisely when capital outflows and currency depreciation dent domestic economic activity. EMEs departed from this playbook in the Covid-19 stress period of March and April 2020. They were able to cut policy rates and ease monetary policy aggressively, thereby supporting domestic activity. Moreover, some also adopted asset purchase programmes (Arslan, Drehmann and Hofmann (2020)). Why was it different this time?
This Bulletin examines the context and drivers of interest rate policy decisions by EME central banks. We compare the interest rate response in three crisis episodes: the Great Financial Crisis (GFC) of 2007–09; the stress period of 2015; and the Covid-19 stress period of March–April 2020 (Graph 1). First, in early 2020 most EMEs were at a relatively low point of the business cycle, with aggregate demand below potential, while structural changes that better anchored inflation expectations and reduced exchange rate pass-through ensured that central banks could cut interest rates without raising inflation risks. Second, broad and bold actions by advanced economy (AE) central banks curbed the appreciation of the US dollar and calmed the turmoil in global financial markets, allowing rates to be cut aggressively in EMEs in spite of large capital outflows and sharp currency depreciations. These two factors made a coordinated policy response between fiscal and monetary authorities in most EMEs possible – even with limited fiscal space. So far, monetary policy and fiscal policy easing have complemented each other in supporting the flow of credit and aggregate demand…”
