Did interest rate guidance in emerging markets work?

Summary

Focus 

Interest rate guidance consists of central bank statements about the future path of policy interest rates. Advanced economies deployed it after the Great Financial Crisis, successfully influencing long-term interest rates, as well as expectations about the economic outlook. It thus proved useful in complementing traditional monetary policy tools during crises or following unexpected shocks. Emerging market economies (EMEs) adopted interest rate guidance only recently, as part of their policy responses to the Covid-19 pandemic. In this paper we study the experience of the central banks of five EMEs during that episode, asking in particular whether their interest rate guidance could provide additional monetary stimulus and influence market expectations in the desired way.

Contribution 

Because EMEs only recently adopted the practice of offering interest rate guidance, starting during a severe external shock that hit all economies simultaneously, little is known about its effects. In this paper, we aim to fill this gap by taking stock of the experience of five EMEs – Brazil, Chile, India, Israel and Peru – that adopted interest rate guidance in 2020–21. We first highlight the key characteristics of the policy statements and quantify their impact on long-term yields, before investigating whether they triggered any potentially negative side effects.

Findings 

We find that, following interest rate guidance statements, long-term local-currency yields fell by between five and 20 basis points across the five EMEs we analyse. This was accompanied by a median reduction in term spreads of about 10 basis points. These statistically and economically significant effects are in line with those documented in advanced economies. Importantly, we do not observe any systematic negative market reaction following the policy statements, such as a de-anchoring of inflation expectations, currency depreciation pressures or a spike in sovereign risk spreads.

Abstract

This paper studies the experience of emerging markets with explicit interest rate guidance during 2020-2021. Despite some heterogeneity, interest rate guidance generally provided additional monetary stimulus, as reflected in lower medium-term yields and lower term spreads. The magnitude of the reduction in 10-year yields ranged between five and twenty basis points, and these effects are found when the policy rate was at its historical minima. Outcome-based guidance appears to have had the largest effects. In the immediate aftermath of the guidance, we do not observe a systematic negative market reaction of the kind that would be associated with a loss of central bank credibility or with concerns about fiscal dominance, such as a de-anchoring of inflation expectations, currency depreciation pressures, or increased sovereign credit risk.

JEL Classification: E52, E58

Keywords: monetary policy; forward guidance; central bank communication; emerging markets