Interest rate uncertainty as a policy tool?

We study an unconventional policy tool – interest rate uncertainty – that may be used to discourage inefficient capital inflows and to adjust the composition of external accounts between short-term securities and foreign direct investment (FDI). We show that identified interest rate volatility shocks in several emerging markets lower GDP growth, raise inflation, improve the current account, and depreciate the real exchange rate. In a calibrated open-economy New Keynesian model, we introduce a policy rule that endogenously adjusts the volatility of interest rate shocks in response to capital-flow drivers. The uncertainty policy discourages short-term portfolio inflows through portfolio-risk and consumption-smoothing channels, while a markup channel, reinforced by exchange-rate depreciation, attracts FDI. The strength of the markup transmission depends on exchange-rate pass-through. The uncertainty policy may be welfare improving if designed against uncertainty shocks that drive capital flows. However, it may be welfare reducing against level shocks that drive capital inflows.