Monetary Policy in the North, Effects in the South

Abstract

We investigate empirically what may be the effects of Monetary Policy in the North-namely monetary policy normalization by the FED and quantitative easing (QE) by the ECB- on cross border portfolio flows to the South (Emerging Markets). Using a Dynamic Linear Factor Augmented VAR (FAVAR), we find that the FED monetary policy normalization may lead to a reduction in capital inflows in emerging markets between 3-7% of GDP. The sharpest reduction occurs when markets overreact to the FED normalization and the ECB follows suit, rather than following a QE path. In turn, the mildest correction in capital inflows occurs in the current situation (i.e., the FED manages to normalize monetary policy smoothly and the ECB frontloads it’s QE). Across regions, Emerging Europe is generally less affected than Latin America and Emerging Asia, the more so the larger the QE by the ECB.