Quantitative Easing in the US and Financial Cycles in Emerging Markets

Abstract

Large international capital movements tend to be associated with strong fluctuations in asset prices and credit, contributing to domestic financial cycles and posing challenges for stabilization policies, especially in emerging market economies. In this paper we argue that these challenges are particularly severe if the global financial cycle is driven by quantitative easing (QE) in the US, and when the local banking sector has large holdings of government bonds, like in many Latin American countries. We first show empirically that a typical round of QE by the US Fed leads to a persistent expansion in credit to households and a significant loss of price competitiveness in this group of economies. We next develop a quantitative macroeconomic model of a small open economy with segmented asset markets and banks, which accounts for these observations. In this framework, foreign QE creates tensions between macroeconomic and financial stability as a contractionary impact of exchange rate appreciation is accompanied by booming credit and house prices. As a consequence, conventional monetary policy accommodation aimed at stabilizing output and inflation would further exacerbate domestic financial cycle. We show that an effective way of resolving this trade-off is to impose a time-varying tax on capital inflows. Combining foreign exchange interventions with tightening of local credit policies can also restore macroeconomic and financial stability, but at the expense of a large redistribution of wealth between borrowers and savers.