Do the World's Central Banks React to Financial Markets?
We investigate if the world's central banks’ setting of monetary policy rates is sensitive to financial variables, controlling for conventional monetary policy determinants. We specify and estimate an extended Taylor rule that includes, in addition to real-time backward and forward-looking inflation and activity variables, three financial variables. First, we include exchange-rate devaluation, reflecting possible fear of floating and fear of devaluation-inflation pass-through. Then we include two financial variables that may indicate bubbles and overheating to test for monetary behavior reflecting leaning against the wind: the change in stock market prices and the growth in bank credit to the private sector. We estimate our model using the Pooled Mean Group estimator applied to an unbalanced world panel of monthly 1994-2011 observations for 28 advanced and emerging economies, representing 80% of the world's GDP. We find that central banks react to changes in exchange rates and credit flows, both in the short term and long term. We also find that industrial-country central banks respond to stock-market returns and exchange-rate changes in the long term, while central banks in emerging economies react to credit flows and exchange rates both in the short and the long term. Finally, we find that inflation-targeting countries take into account exchange rates and credit flow changes either in the long-term or in the short-term. Results are robust to backward and forward-looking inflation and activity variables and to the presence of outliers.
This paper was presented at the "Financial Deepening, Macro-Stability, and Growth in Developing Countries" conference, held jointly by the International Monetary Fund, the World Bank, the Consortium on Financial Systems and Poverty, and the UK Department for International Development in September of 2012.