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That global macroeconomic movements this year have been in large part due to the United States Federal Reserve is so obvious that this paragraph is pointless.
Where the Fed leads, other central banks after often forced to follow, not least to defend their domestic lucre (the “reverse currency wars” that have become so prominent this year).
But a Bundesbank paper published on Monday goes beyond the headline rate hikes and cee-bee ratesetter angst. Authors (intake of breath) Johannes Beutel, Lorenz Emter, Norbert Metiu, Esteban Prieto and Yves Schüler write that the tail risks of financial tightening are well-studied, but that:
. . . the questions of how unexpected changes in U.S. financial conditions and monetary policy affect macroeconomic tail risks in other countries and which country characteristics increase the vulnerability to such changes have received little attention in the literature.
Using Bayesian quantile vector autoregressions (duh) on data from 44 countries, as well as studying GDP impacts and excess bond premium (a cousin of moron risk premium related to corporate bond markets), they found:
— (1) “an exogenous tightening in U.S. financial conditions raises macroeconomic tail risks internationally”
— (2) “an unexpected tightening in U.S. monetary policy also has stronger effects on the lower tail of the conditional GDP growth distribution than on the median and the upper tail”
— (3) “certain country characteristics matter significantly for the international transmission of these shocks on the lower tail of the conditional GDP growth distribution.
Tl;dr, the dollar wrecking ball is very real, and very smashy.
That’s all very well, but the interesting finding is just how those effects are distributed. The gang (our emphasis):
The effect of the shock on the upper tail (90% quantile) is positive and less pronounced than the effect on the median. By contrast, the effect on the lower tail (10% quantile) is substantially stronger than the effect on the median. After four quarters, the effect on the lower tail is roughly four times stronger than on the median.
Here’s how that looks in a chart — basically, when wrecking balls hit directly, they hit hard:
Certain characteristics appear to make the growth impact much worse for those most affected. Specifically, large amounts of foreign-denominated debt, fixed exchange rates, and large amount of domestic leverage (no surprises there).
The best shield against getting smashed is eating a solid meal before going out a floating exchange rate, the researchers reckon:
. . . for the 10% conditional quantile of GDP growth (upper panel), we find that countries with a relatively more flexible exchange rate regime exhibit a significantly more moderate (i.e., less negative) tail response of GDP growth to a U.S. financial shock . ..
From the perspective of our results, this mechanism dominates any potentially stabilising effects of a pegged regime that insulates the economy from large swings in the exchange rate.
The interesting takeaway here seems to be that having these weaknesses is particularly a problem for those who are suffering the most. In terms of a layperson’s analogy, we think this is something like:
— having the upper half of your house set on fire and be destroyed is bad
— having your whole house set on fire, igniting the huge fireworks stash in your basement, is significantly worse
Or, as Beutel et. al put it:
Our results indicate that the strength of the GDP growth response systematically varies with certain country characteristics for the lower tail of the conditional GDP growth distribution but not for the median. Policymakers concerned with the possibility of large negative output growth realizations should therefore pay particular attention to policy choices that expose their economies to elevated GDP tail risks arising from external shocks.
And to those policymakers, we say: good luck!
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