U.S. monetary policy spillovers to emerging market countries: Responses to cost-push and natural rate shocks

The spillover effects of U.S. monetary policy on emerging markets can vary depending on the specific shock. The natural interest rate serves as a crucial benchmark for assessing the stance of monetary policy, for which rate changes can be very impactful. Given the rising frequency and magnitude of structural shocks in the U.S. in recent years, further analysis of how U.S. interest rate changes, particularly under natural rate shocks, affect emerging market economies is essential. Using a new Keynesian small open economy model, we find that under cost-push shocks, the exchange rate depreciates (USD weakens), whereas, under natural rate shocks, it appreciates (USD strengthens). These differences are amplified through domestic bonds (finance channel) and terms of trade (trade channel). Empirical Bayesian local projection results confirm the importance of the exchange-rate channel, with strong evidence supporting finance and weaker evidence for trade channels, likely due to emerging economies’ financial vulnerabilities. We also find that different structural drivers behind natural rate shocks affect the spillover. While addressing external shocks is important, placing excessive focus on this alone is not an effective strategy. Instead, central banks in emerging market economies should carefully balance their responses to external pressures without compromising the autonomy of domestic monetary policy.