New monetary policy tools in emerging market economies

Policy rates constrained at low levels 

With interest rates already at historical lows in the wake of the Covid-19 pandemic (Chart 1), emerging market central banks reacted to the shock by drastically decreasing policy rates in order to set more favourable financing conditions for their economies. This exceptional monetary policy easing phase revealed the limits of the policy space in some economies, as their rates reached close to zero in 2020 and 2021. For others, lowering interest rates would have been counterproductive due to potential capital outflows, currency depreciation and weaker policy transmission (IMF GFSR, October 2020). Lower rates make assets less attractive to foreign investors, leading to tighter financial conditions that could offset the intended stimulus. Moreover, currency weakness can destabilise the economy due to dollar-denominated balance sheets and the pass-through of the exchange rate to inflation. The effective lower bound is therefore reached at well above zero. In this new environment, many central banks in emerging markets (constrained at zero or not) engaged in unconventional monetary policies by implementing interest rate guidance, asset purchase programmes or a combination of both. While the motivations for these moves are similar to those in advanced economies, the particular exposure of emerging markets to external shocks makes implementing and exiting unconventional policies more complex.

Forward guidance  

Forward guidance refers to public communication by a central bank on the likely future path of short-term interest rates. It can take diverse forms such as (a) outcome-based statements (i.e. conditional on the realisation of pre-specified economic outcomes), (b) open-ended statements (i.e. commitments “for an extended period of time”), or (c) calendar-based statements (i.e. specification of the future policy stance for a defined period). When implementing forward guidance, central banks must consider certain trade-offs between abiding to commitments and data-dependent flexibility. On the one hand, if future policy rates do not follow the forward guidance, then markets may perceive this as a failure to deliver on a commitment, potentially harming the bank’s credibility. On the other hand, persisting for too long on a previously signaled path, regardless of developments in the real economy, could de-anchor inflation expectations. 

The main reason emerging market economies engaged in this communication strategy was their lack of policy space in a global environment of low interest rates, as observed in Chart 1. But the opportunity for emerging market central banks to implement forward guidance reflected improvements in their independence and credibility, which in turn resulted from better monetary policy transparency (Dincer, Eichengreen and Geraats, 2022 Chart 2).
 

In the recent period, India, Israel, Chile, Brazil and Peru have implemented forward guidance (Caballero and Gadanecz, 2023). While Brazil and Peru engaged in outcome-based forward guidance, Chile, Israel and India used open-ended statements. No countries engaged in calendar-based guidance, which offers less flexibility. 

Caballero and Gadanecz find that first-time explicit interest rate guidance events were not associated with negative market reactions that would have hinted at a loss of central bank credibility (i.e. de-anchoring of inflation expectations, currency depreciation pressures, or increased sovereign credit risk). Instead, the authors observe a decrease in long-term local-currency yields immediately after these statements, as well as compression of term spreads, confirming the success of forward guidance in these countries. Yet, as pointed out by the authors, the greater reliance on bank credit relative to market-based finance can make forward guidance less effective at influencing long-term yields in emerging markets than in mature markets. 

Employing interest rate guidance in today’s high-for-long inflation environment can prove arduous. Its effectiveness may be tempered by economic uncertainties and the need for adaptive and credible communication strategies. Despite these challenges, interest rate guidance is still used, as shown by the Brazilian Central Bank (Monetary Policy Committee, March 2024) clearly stating its intentions for future rate moves during its easing cycle that started in August 2023. Each country's experience reflects the balance between managing expectations and maintaining flexibility to respond to evolving economic conditions.

Asset purchase programmes

The pandemic triggered the first launch of asset purchase programmes in emerging market economies to reduce financial stress. The IMF's October 2020 Global Financial Stability Report (GFSR) identified three main motivations for emerging market economies to use this tool: (i) to improve bond market functioning and provide liquidity to the financial sector; (ii) to provide additional monetary stimulus to escape from the effective lower bound; and (iii) to explicitly ease government financing pressures. In some countries (i.e. Chile, India and Israel), asset purchases complemented interest rate guidance. 

These programmes, which essentially consisted of central bank purchases of local currency bonds, were much smaller in scale than those of advanced economies, leading to more modest increases in the assets held by emerging market central banks (Hardy and Zhu, 2023). Most of the programmes were short-lived and stopped in 2020.

Overall, asset purchase programmes in emerging markets fulfilled their objectives of easing financial market stress and stabilising bond markets. The programmes helped to reduce government bond yields and spreads relative to US Treasury yields, which surged at the start of the pandemic, while ensuring improvements in market liquidity. Moreover, currency depreciation was avoided and inflation expectations were unaffected (IMF GFSR, 2020). Nonetheless, for these effects to have persisted, emerging market economies should have deployed large-scale asset purchase programmes such as those implemented in advanced economies (Mimir and Sunel, 2023). 

A side effect of bond purchase programmes is their potential usefulness in mitigating the impact of sudden stops in capital inflows (Mimir and Sunel, 2023). Capital outflows and additional sovereign debt issuance during the pandemic were almost entirely absorbed by the domestic banking sector, while central banks played a minor role (Hardy and Zhu, 2023). However, in some economies, through asset purchases, central banks increased their holdings of local currency government bonds by an amount similar to that of capital outflows (Chart 3). 
 

Conclusion

Interest rate guidance and asset purchase programmes have both proved useful in supporting central banks' monetary policies, by enabling them to break free from the low-rate constraint, and were particularly decisive in the response to the Covid-19 crisis. These policies add to the toolbox available to emerging market central banks. In particular, given the current higher-for-longer inflation environment, clear communication remains a useful tool to ensure the operational transmission of domestic monetary policy and reduce uncertainty about the future path of domestic interest rates.