Effects of the U.S. Quantitative Easing on a Small Open Economy

Effects of the U.S. Quantitative Easing on a Small Open Economy César Carrera Fernando Pérez Nelson Ramírez-Rondán Central Bank of Peru November 5, 2014 Ramirez-Rondan (BCRP) US QE and Peru November 5, 2014 1 / 26

A brief overview Quantitative Easing (QE) policies are used in developed economies to stimulate their economies when standard monetary policy has become ineffective (when the short-term interest rate is at its zero lower-bound). A central bank implements QE by purchasing assets of longer maturity, and thereby lowering longer-term interest rates, while simultaneously increasing the monetary base. In November 2008, the Federal Reserve started buying mortgage-backed securities, treasury securities and other financial assets in different rounds (QE1, QE2, operation twist and QE3.) Ramirez-Rondan (BCRP) US QE and Peru November 5, 2014 2 / 26

A brief overview FED s Quantitative Easing Figure: FED s Balance Sheet 4500 4000 3500 Others Securities Held Outright Support for Specific Institutions All Liquidity Facilities 3000 of US$ Billions o 2500 2000 1500 1000 500 0 1-Aug-07 7-May-08 11-Feb-09 18-Nov-09 25-Aug-10 1-Jun-11 7-Mar-12 12-Dec-12 18-Sep-13 Source: Federal Reserve Economic Data (FRED) Ramirez-Rondan (BCRP) US QE and Peru November 5, 2014 3 / 26

A brief overview Contribution and main result Most of the work on QE is focused on developed countries. However, US quantitative easing policies also have spillover effects on developing countries. After each US QE round, most emerging economies may have experienced large surges in capital inflows, which led to exchange rate appreciation, high credit growth, asset price booms, among other effects. Ramirez-Rondan (BCRP) US QE and Peru November 5, 2014 4 / 26

A brief overview Contribution and main result Most of the work on QE is focused on developed countries. However, US quantitative easing policies also have spillover effects on developing countries. After each US QE round, most emerging economies may have experienced large surges in capital inflows, which led to exchange rate appreciation, high credit growth, asset price booms, among other effects. Contribution: this paper assesses empirically the US QE effects on the Peruvian Economy. We focus on economic growth and inflation. Ramirez-Rondan (BCRP) US QE and Peru November 5, 2014 4 / 26

A brief overview Contribution and main result Most of the work on QE is focused on developed countries. However, US quantitative easing policies also have spillover effects on developing countries. After each US QE round, most emerging economies may have experienced large surges in capital inflows, which led to exchange rate appreciation, high credit growth, asset price booms, among other effects. Contribution: this paper assesses empirically the US QE effects on the Peruvian Economy. We focus on economic growth and inflation. Main result: we find effects on financial variables but small effects on inflation and growth, based on a structural VAR (SVAR) model with block exogeneity (Zha, 1999) and sign and zero restrictions (Arias, Rubio-Ramirez, y Waggoner, 2014). Ramirez-Rondan (BCRP) US QE and Peru November 5, 2014 4 / 26

Outline 1 Related literature 2 Empirical strategy 3 Counterfactual analysis 4 Conclusion Ramirez-Rondan (BCRP) US QE and Peru November 5, 2014 5 / 26

Related literature Baumeister and Benati (2012): SVAR with sign restrictions for QE effects in the U.S. and the U.K. and find that compressions in the long-term yield spread exert a powerful effect on both output growth and inflation. Schenkelgerg and Watzka (2013): SVAR with zero and sign restrictions for QE effects in Japan and find that a QE shock leads to a 7 percent drop in long-term interest rates and a 0.4 percent increase in industrial production. Ramirez-Rondan (BCRP) US QE and Peru November 5, 2014 6 / 26

Related literature Main channels highlighted about QE effects for developing countries: Liquidity channel, increased global liquidity leads to investors searching for investment opportunities in emerging markets (increase of capital inflows to emerging economies). This induces higher credit growth. Exchange-rate channel, increase in capital inflows implies an exchange rate appreciation. Central banks that reduce the volatility in forex market accumulates international reserves. Trade channel, the increase in output growth in advanced economies, increases demand for exports from emerging markets. Terms-of-trade channel, investors bought gold with part of the excess of liquidity. Relevant for mineral exporter countries (e.g. Chile, Peru). Ramirez-Rondan (BCRP) US QE and Peru November 5, 2014 7 / 26

Empirical strategy SVAR with block exogeneity The approach considers a two-block SVAR model featuring (1) the big economy and (2) a the small open economy. Where the last block is exogenous for the first one. Cushman and Zha (1997) argue that the imposition of block exogeneity in a SVAR is a natural extension for a small open economy model because it helps the identification of the monetary policy from the viewpoint of this small open economy. The use of block exogeneity also reduces the number of parameters needed to estimate for the small open economy block. Ramirez-Rondan (BCRP) US QE and Peru November 5, 2014 8 / 26

Empirical strategy The setup The big economy (US economy): y t A 0 = p i=1 y t ia i + w td + ε t (1) where yt is n 1 vectors of endogenous variables for the big economy; ε t is n 1 vectors of structural shocks for the big economy (ε t N(0, I n )); Ã i and A i are n n matrices of structural parameters for i = 0,..., p; w t is a r 1 vector of exogenous variables; D is r n matrx of structural parameters; p is the lag length; and, T is the sample size. Ramirez-Rondan (BCRP) US QE and Peru November 5, 2014 9 / 26

Empirical strategy The setup The small open economy (Peruvian economy): y ta 0 = p y t ia i + i=1 p i=0 y t iã i + w td + ε t (2) where y t is n 1 vector of endogenous variables for the small economy; ε t is n 1 vector of structural shocks for the domestic economy (ε t N(0, I n ) and structural shocks are independent across blocks i.e. E(ε t ε t ) = 0 n n ); A i are n n matrices of structural parameters for i = 0,..., p; and, D is r n matrix of structural parameters. Ramirez-Rondan (BCRP) US QE and Peru November 5, 2014 10 / 26

Empirical strategy The setup Compact form: [ y t y t ] [ A 0 à 0 0 A 0 ] = p i=1 +w t [ y t i y t i [ D D ] [ A i à i 0 A i ] + [ ε t ε t ] ] [ I n 0 0 I n ] Ramirez-Rondan (BCRP) US QE and Peru November 5, 2014 11 / 26

Empirical strategy Data Monthly data: October 1995-December 2013. Variables from the US economy: Economic policy uncertainty index (EPU US ). Term spread indicator (Spread). M1 Money Stock (M1 US ). Federal Funds Rate (FFR). Consumer Price Index (CPI US ). Industrial Production Index (IP US ). Ramirez-Rondan (BCRP) US QE and Peru November 5, 2014 12 / 26

Empirical strategy Data Variables from the Peruvian economy: Terms of trade (TOT). Real Exchange Rate (RER). Interbank Interest Rate in Soles (INT). Aggregated Credit of the Banking System in US Dollars (Cred FC ). Aggregated Credit of the Banking System in Soles (Cred DC ). Consumer Price Index (CPI). Real Gross Domestic Product (GDP). Ramirez-Rondan (BCRP) US QE and Peru November 5, 2014 13 / 26

Empirical strategy Identifying QE shocks QE shock: lowering longer-term interest rates, while simultaneously increasing the monetary base and keeping the federal fund rate low. 2800 2600 2400 2200 (a) US M1 money stock (b) Long- and short-term interest rates 7.0 10-Year Treasury Constant Maturity Rate Effective Federal Funds Rate 6.0 5.0 2000 4.0 1800 1600 1400 3.0 2.0 1200 QE1 QE2 QE3 1.0 QE1 QE2 QE3 1000 01Q1 02Q1 03Q1 04Q1 05Q1 06Q1 07Q1 08Q1 09Q1 10Q1 11Q1 12Q1 13Q1 0.0 2007 Q1 2008 Q1 2009 Q1 2010 Q1 2011 Q1 2012 Q1 2013 Q1 Source: FRED. Ramirez-Rondan (BCRP) US QE and Peru November 5, 2014 14 / 26

Empirical strategy Identifying QE shocks Table: Identifying Restrictions for a QE shock in the U.S. Variable QE shock US term spread indicator (Spread) US M1 money stock (M1 US ) + Federal Funds Rate (FFR) 0 Other US variables? Domestic (Peru) block? Note:? = left unconstrained. Baumeister and Benati (2012) and Peersman (2011) impose similar identification for the US economy and the Euro area, respectively. Ramirez-Rondan (BCRP) US QE and Peru November 5, 2014 15 / 26

Empirical strategy Responses after a QE shock Figure: U.S. responses after a QE shock; median value and 68% bands 20 EPU US 0.05 Spread 10 0 0.05 0 0.1 10 15 30 45 60 0.15 15 30 45 60 M1 US 0.1 FFR 0.6 0.05 0 0.4 0.05 0.2 0.1 15 30 45 60 0.15 15 30 45 60 CPI US IP US 0.3 0.6 0.2 0.4 0.1 0.2 0 0 0.1 15 30 45 60 0.2 15 30 45 60 Ramirez-Rondan (BCRP) US QE and Peru November 5, 2014 16 / 26

Empirical strategy Responses after a QE shock Figure: Peruvian responses after a QE shock; median value and 68% bands 2 TOT 1 RER 1.5 INT 0 0 1 2 4 1 0.5 6 2 0 8 15 30 45 60 3 15 30 45 60 0.5 15 30 45 60 10 Cred FC 4 Cred DC 1.5 CPI 5 2 1 0 0.5 0 2 0 5 15 30 45 60 4 15 30 45 60 0.5 15 30 45 60 1 GDP 0.5 0 0.5 1 Ramirez-Rondan 15 (BCRP) 30 45 60 US QE and Peru November 5, 2014 17 / 26

Counterfactual analysis The setup Pesaran and Smith (2012) define a policy effect relative to the counterfactual of no policy scenario. Suppose that the policy intervention is announced at the end of the period T for the periods T + 1, T + 2,..., T + H. The intervention is such that the policy on realized values of the policy variable are different from the policy off counterfactual values (what would have happened in the absence of the intervention). Ramirez-Rondan (BCRP) US QE and Peru November 5, 2014 18 / 26

Counterfactual analysis The setup Ω T = {x t for t = T, T 1, T 2,...} is the information set available at time t. Let m t be the policy variable. The realized policy values are: Ψ T +h (m) = {m T +1, m T +2,..., m T +h }. The counterfactual policy values are: Ψ T +h (m 0 ) = {m 0 T +1, m0 T +2,..., m0 T +h }. Ramirez-Rondan (BCRP) US QE and Peru November 5, 2014 19 / 26

Counterfactual analysis Ex-ante policy evaluation Compare the effects of two alternative sets of policy values: Ψ T +h (m 0 ) and Ψ T +h (m 1 ). The ex-ante effect of the policy on Ψ T +h (m 1 ) relative to policy off Ψ T +h (m 0 ) is given by: d t+h = E(z t+h Ω T, Ψ T +h (m 1 )) E(z t+h Ω T, Ψ T +h (m 0 )), h = 1, 2,..., H, (3) where z t is one of the variables in the matrix x t (for example, inflation in Peru), except the policy variable(s). Ramirez-Rondan (BCRP) US QE and Peru November 5, 2014 20 / 26

Counterfactual analysis Counterfactual scenario Figure: U.S. M1 Money Stock 2800 2600 2400 US M1 Money stock Counterfactual scenario for QE1 Counterfactual scenario for QE2, op. twist and QE3 2200 2000 1800 1600 1400 1200 Op. QE1 QE2 QE3 twist 1000 ene-00 ene-01 ene-02 ene-03 ene-04 ene-05 ene-06 ene-07 ene-08 ene-09 ene-10 ene-11 ene-12 ene-13 Ramirez-Rondan (BCRP) US QE and Peru November 5, 2014 21 / 26

Counterfactual analysis Ex-ante results Table: QE effects throughout the U.S. M1 in the U.S. (keeping low the FED interest rate) QE ex-ante effect Median 68% lower 68% upper QE1 bound bound M1 Money stock (% change) 8.23 FED interest rate (p.p) 0.00 Term spread (p.p) -0.19-0.20-0.17 Inflation rate (%) 0.95 0.92 0.97 Industrial production (%) 2.43 2.32 2.54 Ramirez-Rondan (BCRP) US QE and Peru November 5, 2014 22 / 26

Counterfactual analysis Ex-ante results Table: QE effects throughout the U.S. M1 in Peru (keeping low the FED interest rate) QE ex-ante effect Median 68% lower 68% upper QE1 bound bound Terms of trade (% change) 5.51 5.16 5.83 Exchange rate (% change) -3.19-3.39-2.94 Interest rate (p.p) -0.29-0.35-0.25 Credit in U.S. dollars (%) 6.41 6.13 6.65 Credit in Soles (%) 4.72 4.48 4.95 Inflation rate (%) 0.48 0.43 0.53 Activity growth (%) 0.21 0.11 0.35 Ramirez-Rondan (BCRP) US QE and Peru November 5, 2014 23 / 26

Conclusion Our results suggest small effects of US QE on key macroeconomic variables. The increase in international liquidity seems to transmit effects over the macro-economy through channels such as interest rates, credit growth, and exchange rate. But, we find not significant effects on inflation and economic growth in Peru. In that regard, our prior is that the central bank anticipated most of those effects and adopted macroprudential policies that mitigate any negative effect that may spread over the whole Peruvian economy. Ramirez-Rondan (BCRP) US QE and Peru November 5, 2014 24 / 26

Agenda Include variables that capture other transmission channels: Portfolio re-balancing channel and Signaling channel, that operates through the effect on agents expectations. Include macroprudential variables: reserve requirements and forex market interventions (control of exchange rate variability); which might tend to mitigate most of the transmission mechanism. QE1 (a program to purchase agency debt and MBS to provide greater support to mortgage lending and housing markets ) vs QE2 ($300 billion in long-term Treasuries to help improve conditions in private credit markets ) Estimate the effects in other countries (Chile, Colombia and Mexico) Look at QE Exit (Tapering) Ramirez-Rondan (BCRP) US QE and Peru November 5, 2014 25 / 26

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