International long-term yields and monetary policy in a small open economy: The case of Canada

Abstract

The objective of this study is to identify the impact of the recent period of international integration of bond markets on interest rates in a small open economy. The empirical methodology captures a financial globalization regime with a nonlinear, structural vector autoregression (SVAR) and a regime-switching contemporaneous interest-rate block. The responses of longer term interest-rate spreads in Canada to changes in U.S. long-term nominal interest rates are found to have increased by about one-third in the globalization regime since the late 1990s, consistent with recent research on the effects of international long-term yields on those in small open economies. There is also some evidence of a weaker response of the longer term spreads, a measure of the stance of policy in Canada, to the monetary policy rate in the globalization regime. However, the evidence does not support an important decoupling of short- and long-term interest rates that has made the monetary transmission mechanism less effective for controlling economic activity and inflation. In fact, monetary policy appears to have become even more effective in the globalization regime as result explicit inflation targeting.