The textbook uncovered interest parity (UIP) condition states that the expected change in the exchange rate between two countries over time should be equal to the interest rate differential at that horizon. While UIP appears to hold at longer horizons (around 5-10 years), it is regularly rejected at shorter ones (0-4 years). In a recent paper, we argue that interest rates at other maturities — captured in the slope of the yield curve — reflect information about the pricing of ‘business cycle risks’, which can help explain departures from UIP. A country with a relatively steep yield curve slope will tend to experience a depreciation in excess of the UIP benchmark, at business cycle frequencies especially.
The Covid-19 pandemic has led to both a decline in economic activity that has been propagated across borders through global supply networks, and a rise in barriers to trade between countries. This has led to a rapidly emerging literature seeking to understand the effects of the pandemic on trade. This post surveys some of the key contributions of that literature. Key messages from early papers are that: i) The shock is a hit to both demand and supply, and is thus deeper than what was experienced during the 2008/09 Great Trade Collapse; ii) Global value chains have amplified cross-country spillovers; iii) When supply chains are highly integrated, protectionist measures can disrupt production of medical equipment and supplies; and, hence, iv) Keeping international trade open during the crisis can help to limit the economic cost of the pandemic and foster global growth during the recovery.
The average house in the UK is worth ten times what it was in 1980. Consumer prices are only three times higher. So house prices have more than trebled in real terms in just over a generation. In the 100 years leading up to 1980 they only doubled. Recent commentary on this blog and elsewhere argues that this unprecedented rise in house prices can be explained by one factor: lower interest rates. But this simple explanation might be too simple. In this blog post – which analyses the data available before Covid-19 hit the UK – we show that the interest rates story doesn’t seem to fit all of the facts. Other factors such as credit conditions or supply constraints could be important too.
Prudential policies have grown in popularity as a tool for addressing financial stability risks since the 2007-09 global financial crisis. Yet their effects are still debated, with sanguine and more pessimistic viewpoints. In a recent Bank of England Staff Working Paper, we assess the extent to which emerging market (EM) prudential policies can partially insulate their domestic economies against the spillovers from US monetary policy. Using a database of prudential policies implemented by EMs since 2000, our estimates indicate that each additional prudential policy tightening can dampen the decline in total credit following a US monetary policy tightening by around 20%. This suggests that domestic prudential policies allow EMs to insulate themselves somewhat from global shocks.
Asset prices tend to co-move internationally, in what is often described as the ‘global financial cycle’. However, one such asset class, exchange rates, cannot by definition all move in the same direction. In this post we show how the ‘global financial cycle’ is associated with markedly different dynamics across currencies. We enrich traditional labels such as ‘safe haven’ and ‘risky’ currencies with an explicit quantification of exchange rate tail risks. We also find that several popular ‘risk factors’, such as current account balances and interest rate differentials, can be linked to these differences.
How sound is the argument that current account balances are driven by demographics? Our multi-country lifecycle model explains 20% of the variation in observed net foreign asset positions among advanced economies through differences in population age structure. These positions should expand further as countries continue to age at varying speeds.
From the introduction of the Euro up to the 2008 global financial crisis, macroeconomic imbalances widened among Member States. These imbalances took the form of strong differences in the dynamics of unit labour costs, which increased much faster in ‘peripheral’ economies than in ‘core’ countries. At first, these imbalances were interpreted as reflecting a catch-up and convergence process within the Euro Area – and were supposed to fall as countries converged. But, more recently economists and policymakers have challenged this view, suggesting that imbalances reflected a broader competitiveness problem in the ‘periphery’ compared to the ‘core’ countries. This post, based on a recent Staff Working Paper, revisits the effect of economic integration on macroeconomic imbalances.
Capital flows are fickle. In the UK, the largest and most volatile component of inflows from foreign investors are so-called ‘other investment flows’ – the foreign capital which flows into banks and other financial institutions. But where do these funds ultimately go and which sectors are particularly exposed to fickle capital inflows? Do capital inflows allow domestic firms to borrow more? Or does capital from abroad ultimately finance mortgages of UK households? Some of the foreign capital could also get passed on to the financial sector or flow back abroad.
Much has been written on the global decline of the corporate labour share (defined as the share of corporate value added going to wages, salaries and benefits). The IMF and OECD worry about this trend, linking it to decreasing wages and rising inequality. And economists are hard at work looking for an explanation: prominent hypotheses range from automation and ‘superstar’ firms to offshoring. But is there really a global decline in the non-housing/business labour share? Not if you properly exclude housing income and account for self-employment, as described in a recent Staff Working Paper. Adjusting for housing and self-employment, labour shares have remained stable across most advanced economies except in the US, where the labour share still declines by 6% since 1980 (Figure 1).
According to conventional wisdom, a currency area benefits from internal labour mobility. If independent stabilisation policies are unavailable, the argument goes, factor mobility helps regions respond to shocks. Reasonable as it sounds, few attempts have been made to test this intuition in state-of-the-art macroeconomic models. In a recent Staff Working Paper (also available here), we build a DSGE model of a currency area with internal migration to go through the maths. So does the old intuition hold up? The short answer, we think, is yes. Internal labour mobility eases the burden on monetary policy by reducing regional labour markets imbalances. But policymakers can improve welfare by putting greater weight on unemployment. Effectively, interregional migration justifies a somewhat higher ‘lambda’.