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BIS Bulletin No 32 Summary: Monetary Policy Response in Emerging Market Economies – Why Was It Different This Time?

Core Content

This BIS Bulletin explores the monetary policy response of emerging market economies (EMEs) during the Covid-19-induced financial stress in March 2020. It contrasts this response with those of previous crises (the Great Financial Crisis (GFC) of 2007–09 and the 2015 stress period) to highlight the unique factors that enabled EMEs to adopt a countercyclical monetary policy despite the sharp currency depreciation and massive capital outflows.

Main Points

1. Departure from the Traditional Playbook

• In previous crises, EME central banks typically tightened monetary policy to stem capital outflows and stabilize currencies.
• During the Covid-19 period, EMEs cut interest rates and eased monetary policy, supporting domestic economic activity.
• This was a departure from conventional practice, as EMEs usually face pressure to maintain tight monetary policy during financial stress.

2. Key Drivers of the Different Response

a. Cyclical Conditions

• In early 2020, EMEs were in a low point of the business cycle, with economic slack and inflation below or near targets.
• This allowed central banks to cut rates without raising inflation risks, in contrast to the GFC, when EMEs were in expansionary phases with positive inflation gaps.

b. Structural Improvements

• Inflation expectations were better anchored due to increased credibility and independence of EME central banks.
• Exchange rate pass-through was reduced, which helped stabilize inflation dynamics and lower the sensitivity of inflation to external shocks.
• Long-term inflation expectations had converged closer to targets, enhancing the effectiveness of monetary easing.

c. Advanced Economy (AE) Policy Actions

• Swift and aggressive easing by AE central banks (especially the Federal Reserve) curbed US dollar appreciation and calmed global financial markets.
• This improved EMEs' financial conditions, reducing tail risks and supporting domestic policy easing.
• AE central banks used unprecedented tools, such as swap lines and the FIMA Repo Facility, to provide US dollar liquidity to EMEs.

3. Monetary and Fiscal Policy Synergy

• Fiscal policy also played a crucial role, with EMEs adopting larger fiscal responses than in previous crises.
• Fiscal and monetary policies supported each other:
  • Fiscal stimulus helped offset the economic impact of the crisis.
  • Monetary easing and asset purchases cushioned the impact of portfolio outflows on sovereign bond markets.
  • Fiscal interventions (e.g., loan guarantees) insulated central banks from credit risk, supporting their operational independence.

4. Impact on Financial Markets

• Financial conditions in EMEs began to ease one month after the shock.
• Central banks implemented multiple interventions, including:
  • Domestic lending operations
  • Funding facilities
  • Direct lending to the private sector
  • FX market interventions
  • Asset purchase programmes
• These actions provided liquidity and prevented fire sale spirals in sovereign bond markets.

5. Challenges and Risks Ahead

• The second wave of the pandemic and economic recovery may stress fiscal and monetary positions further.
• Risks include:
  • Sudden stops in capital flows
  • Rising inflation due to confidence erosion and uncertainty
  • Higher sovereign yields from increased government debt
  • Adverse fiscal-monetary loops as inflationary pressures and debt sustainability become more pronounced.
• Structural reforms remain critical to sustain long-term growth and reduce vulnerabilities.

6. Conclusion

• The Covid-19 shock was unprecedented in its magnitude and global impact.
• EMEs were able to cut rates aggressively due to improved cyclical and structural conditions and support from AE central banks.
• However, EMEs are not immune to sudden capital outflows or inflationary risks.
• The need for structural reforms is more urgent than ever to ensure resilience and sustainable growth.

Key Takeaways Recap

• EMEs cut rates in 2020 despite currency depreciation and capital outflows.
• Two main factors enabled this: economic slack and anchored inflation expectations, along with AE monetary easing.
• Fiscal and monetary policies worked synergistically to support credit flow and aggregate demand.
• Challenges remain, including fiscal sustainability, inflation risks, and structural reforms.

References

• Alberola, E, Y Arslan, G Cheng and R Moessner (2020): "The fiscal response to the Covid-19 crisis in advanced and emerging market economies", BIS Bulletin, no 23, June.
• Arslan, Y, M Drehmann and B Hofmann (2020): "Central bank bond purchases in emerging market economies", BIS Bulletin, no 20, June.
• Banerjee, R, A Mehrotra and F Zampolli (2020): "Inflation at risk from Covid-19", BIS Bulletin, no 28, July.
• Carstens, A (2020): "The Great Reallocation", Project Syndicate, 12 October.
• Cavallino, P and F De Fiore (2020): "Central banks' response to Covid-19 in advanced economies", BIS Bulletin, no 21, June.
• Yetman, J (2020): "Pass-through from short-horizon to long-horizon inflation expectations, and the anchoring of inflation expectations", BIS Working Papers, no 895, October.