Monetary Independence under Floating Exchange Rates: Evidence Based on International Breakeven Inflation Rates

Abstract

It is widely assumed that, under flexible foreign exchange (FX) rates, countries may pursue an independent monetary policy with respect to domestic goals. By contrast, recent empirical evidence suggests that, similar to pegs, floating regimes are affected by transmissions of nominal quantities such as inflation or nominal interest rates from abroad. For the case of a four dimensional subsystem of the G7, we highlight the strength of international comovements in liquidity adjusted breakeven inflation interpreted as a measure of future inflation prospects. Results indicate that economies with geographical proximity and strong trade linkages (e.g. Canada and the U.S., the UK and EMU) share highest realized correlations of nonstationary breakeven rates. Moreover, these linkages appear strengthened if corresponding exchange rates are relatively stable or if the respective large economy is in a state of relatively uncertain inflation expectations.