New tools for a new era: an analysis of the federal reserve's influence on emerging market interest rates under varying risk regimes.
The 2007-2009 financial crisis rendered the Federal Reserve’s primary policy tool, the federal funds rate, ineffective once it reached its lower bound. This gave rise to unconventional monetary policy now known as quantitative easing. This new tool allowed emerging markets to obtain record low interest rates on debt financing but also influenced the direction of their local monetary policy. This thesis explores the impact of Federal Reserve policy on emerging market interest rates using weekly data from January 2000 through April 2012. We utilize basic interest rate parity theory as the primary transmission mechanism. We proxy Fed policy after late 2008 by utilizing the week-on-week growth of the Fed’s balance sheet. In addition, we analyze the effectiveness of capital controls in limiting the influence of these external effects on domestic interest rate and examine the role global risk aversion plays in this process. We find that capital controls provide some buffers to emerging markets but the effect varies depending on the period of analysis, as does the effect of risk sentiment. The net effect of the quantitative easing is downward pressure on local interest rates; those with capital controls in place partially mitigate this effect.