How Powell Protects Your Economy, According to the Bundesbank

Global macroeconomic movements this year have been in large part due to the United States Federal Reserve, which is so obvious that this paragraph is pointless.

Where the Fed leads, other central banks are often forced to follow, at least in defense of their domestic earnings (the “reverse currency wars” that have become so prominent this year).

But the Bundesbank paper published on Monday goes beyond major interest rate hikes and concern over rate-fixing. The authors write (taking a breath) Johannes Beutel, Lorenz Emtter, Norbert Mitteo, Esteban Prieto, and Yves Schuller that the risks of financial distress are well thought out, but this:

. . . Questions about how unexpected changes in financial conditions and monetary policy in the United States affect macroeconomic risks in other countries, and what characteristics of countries increase vulnerability to such changes, have received little attention in the literature.

Using an automatic Bayesian quantitative vector (duh) regression process on data from 44 countries, as well as examining the effects of GDP and excess bond premiums (a relative of the moderate risk premium related to corporate bond markets), they found:

(1) “External tightening in US financial conditions increases macroeconomic risks at the international level.”
– (2) “An unexpected tightening in US monetary policy also has stronger effects on the lower tail of the conditional GDP growth distribution than on the median and upper tail.”
(3) “Specific country characteristics are of great importance for the international transmission of these shocks on the bottom of the conditional distribution of GDP growth.

TL; Doctor, the dollar wrecking ball is very real and very cute.

This is all very well, but an interesting discovery is how these effects are distributed. The gang (our focus):

The effect of shock on the upper tail (90% quantitative) is positive and less pronounced than the effect on the median. By contrast, the effect on the lower tail (10% quantitative) is much stronger than the effect on the mean. after four quarters, The effect on the lower tail is about four times stronger than that on the average.

Here’s how that looks in the graph – basically, when you hit wrecking balls directly, they hit hard:

Some properties seem to make a growth effect Many Worse for those hardest hit. Specifically, large amounts of debt denominated in foreign currencies, fixed exchange rates, and a large amount of domestic leverage (no surprises there).

It is the best shield against shattering Eat a solid meal before you go out Floating exchange rate, researchers believe:

. . . For the 10% conditional quantity of GDP growth (upper panel), we find that countries with a relatively more flexible exchange rate regime show a more moderate (i.e., less negative) response to GDP growth to a US fiscal shock. ..

From the perspective of our results, any potential stabilizing effects of a currency peg system that insulates the economy from large fluctuations in the exchange rate are dominated by this mechanism.

The interesting takeaway here seems to be that having these vulnerabilities is especially problematic for those who suffer the most. In terms of a layman’s analogy, we think this is something like:

Setting fire to the upper half of your house and destroying it is bad
Setting your whole house on fire, lighting your huge stockpile of fireworks in your basement, is much worse

Or, as Beutel et. put it:

Our findings indicate that the strength of the GDP growth response varies systematically with specific country characteristics for the lower tail of the conditional GDP growth distribution but not for the mean. Therefore policymakers concerned with the possibility of significant negative output growth should pay particular attention to policy choices that expose their economies to high GDP risks arising from external shocks.

To these policy makers we say: Good luck!