Managing the Yield Curve in a Financially Globalized World

It has been increasingly argued that highly globalized financial markets have been playing a bigger role in determining domestic asset prices and long-term interest rates. Rey (2013) argues that global financial cycles essentially dictate the movements of domestic financial markets to such an extent that policy makers have to decide between either retaining monetary autonomy by imposing capital controls, or retaining free capital mobility but relinquishing monetary independence. In such a world, managing long-term interest rates through manipulating short-term interest rates can be difficult. In this paper, we empirically examine whether net capital inflows contribute to weakening the link between short-term and long-term interest rates. We find that economies open to cross-border capital flows or with more developed financial markets tend to have a greater negative relationship between net capital inflows and interest rate pass-through. We also examine whether macroprudential policies can affect the extent of interest rate pass-through and find that broad-based capital macroprudential tools are effective in retaining control of short- to long-term interest rate pass-through.