## ONLINE ANNEX 1.1. TECHNICAL NOTE

## Source details

**Canonical URL:** [ONLINE ANNEX 1.1. TECHNICAL NOTE](https://www.imf.org/-/media/files/publications/gfsr/2020/october/english/onlineannex11.pdf)

## Other formats

- [Markdown version](/-/media/files/publications/gfsr/2020/october/english/onlineannex11.pdf.md)
- [Structured JSON version](/-/media/files/publications/gfsr/2020/october/english/onlineannex11.pdf.json)

---

### A. Low Growth and Low Inflation Expectations in the Post–COVID-19 World: A Market-Based Perspective

- Key observation:
  - The US 10-year real yield—derived from Treasury inflation-protected securities—has declined sharply since the COVID-19 sell-off.
  - Real yields spiked during the brief sell-off in the Treasury securities market in early March, prior to the Federal Reserve’s quantitative easing announcement on March 15 and after the Federal Open Market Committee meeting.

- Methodology and measurement issues:
  - Breakeven inflation is computed as the difference between nominal and real yields for a given maturity.
  - Two potential distortions in breakevens:
    - US Treasury inflation-protected securities are generally less liquid than their nominal counterparts, especially during periods of market stress.
    - Breakevens incorporate an inflation risk premium—the compensation investors require for bearing inflation risk.
  - Breakevens are decomposed into expected inflation and inflation risk premium components, adjusting for Treasury inflation-protected securities illiquidity as captured by both volume- and price-based metrics.
  - Breakeven inflation decompositions use a variant of the framework put forth by Abrahams and others (2016).
  - Option-implied densities are approximated by a parametric density of skew normal form.

- Empirical findings (market-implied measures):
  - Five-year market-implied average expected inflation:
    - Fell notably early this year, but has recovered somewhat.
  - Five- to ten-year inflation expectations:
    - Declined to slightly below 2 percent and appear to have settled around this lower level.
  - Inflation risk premiums:
    - Currently in negative territory, especially at longer horizons, reflecting market expectations of low inflation coinciding with low output growth.
  - Option-implied probabilities for five-year expected inflation (United States, end of July):
    - Probability of inflation falling below 1 percent: about 25 percent (compared with 20 percent around the end of January and 12 percent at the end of 2019).
    - The same probability spiked to about 85 percent at the time of the COVID-19 sell-off (week of March 23).
  - Distributional pattern:
    - In the United States, the probability of "low" inflation (below 1 percent) is almost four times that of "high" inflation (above 3 percent), with high inflation on a declining trend for the better part of the past decade.
    - In the euro area, the odds of low inflation remain elevated at about 60 percent.
  - Interpretation:
    - The recent upward movement in five-year market-implied inflation expectations after the March sell-off—especially in the United States—largely represents a reversion toward a preexisting downward trend that emerged after the global financial crisis.

- Conceptual note:
  - In a supply shock (for example, an oil shock), low output growth would tend to coincide with high inflation, requiring a positive inflation risk premium.
  - In a demand shock, low output growth coincides with low inflation; nominal bonds may act as “deflation hedges,” leading to a low or negative inflation risk premium.

### B. Spillovers from Monetary Policies in Major Advanced Economies to Emerging Market Economies

- Conceptual channels:
  - Expansionary monetary policy in major advanced economies (policy rate cuts, forward guidance, asset purchases) eases financial conditions in emerging market economies via:
    - Decline in long-term bond yields in major advanced economies putting downward pressure on emerging market economy long-term bond yields through portfolio balance channels.
    - Resulting rise in emerging market economy asset prices and decline in risk premiums.
    - Appreciation of emerging market economy currencies, especially for countries with large foreign currency exposures.
  - Spillovers may be desirable or undesirable depending on the state of emerging market economy business cycles.

- Empirical stylized facts:
  - US Federal Reserve actions exert particularly large spillovers to emerging market economies, reflecting the dollar’s predominant role as a funding currency and in trade invoicing.
  - Main takeaways from the literature:
    - US monetary policy actions have large effects on emerging market economy sovereign bond yields, particularly at longer maturities.
    - A US policy easing that depresses US 10-year yields by 100 basis points tends to reduce 10-year emerging market economy bond yields by roughly one-third to one-half as much, with particularly large effects in the post-global financial crisis period.
    - Pass-through from US forward guidance and asset purchases to emerging market economy bond yields is broadly commensurate with other US policy instruments.
    - US Federal Reserve easing raises emerging market economy equity prices, leads to significant capital inflows, higher corporate leverage, and boosts emerging market economy currencies.
    - Spillovers vary substantially across emerging market economies, typically larger for economies with higher financial openness.

- Rough quantitative estimates related to COVID-19 period:
  - Estimated pass-through from US policy actions since COVID-19:
    - Reduced emerging market economy long-term bond yields in the range of 30–60 basis points.
    - Induced emerging market economy currencies to appreciate by several percentage points.
  - Observed change:
    - Emerging market economy 10-year bond yields have declined by roughly 120 basis points since their peak in mid-March.
    - A straight read of the pass-through estimates suggests about one-quarter to one-half of the 120 basis point decline is attributable to US Federal Reserve easing since the onset of COVID-19.

- Caveats and policy implications:
  - Estimates should be interpreted with caution due to unique features of the COVID-19 crisis and potential differences from post-global financial crisis transmission.
  - In the near term, financial spillovers from accommodative monetary policy in major advanced economies are likely to support emerging market economies facing weak aggregate demand and tight financial conditions, helping cushion downside risks.
  - The more synchronized global downturn in the COVID-19 crisis contrasts with the post-global financial crisis experience when emerging market economies recovered faster; in that earlier episode, accommodative policies in advanced economies induced large capital inflows and overly-easy financial conditions, posing challenges for emerging market economy policymakers.

- Selected quantitative estimates from the literature (Online Annex Table 1.1.1; effects of a US policy shock increasing US 10-year yields by 100 basis points):
  - Bowman and others (2015), Full sample (1/2007–12/2013):
    - 56 basis points (ΔEME basket yield)
    - 200 basis points (effect on foreign exchange rate)
  - Curcuru and others (2018), Full sample (1/2002–12/2017):
    - 32 basis points (avg. ΔEME 10Y yield)
    - 211 basis points (effect on foreign exchange rate)
    - Post-global financial crisis (1/2010–12/2017): 48 basis points (avg. ΔEME 10Y yield); 427 basis points (effect on foreign exchange rate)
  - Caballero and Kamber (2019):
    - Pre-zero lower bound (1/1999–9/2008): 35 basis points (avg. ΔEME 10Y yield)
    - Post-zero lower bound (4/2009–12/2015): 76 basis points (avg. ΔEME 10Y yield)
  - Albagli and others (2019), Full sample (1/2003–12/2016):
    - 2-year: 16 basis points; 10-year: 29 basis points; 352 basis points (effect on foreign exchange rate)
    - Post-global financial crisis (10/2008–12/2016): 2-year: 29 basis points; 10-year: 56 basis points; 666 basis points (effect on foreign exchange rate)

- Notes on table interpretation:
  - Estimates are either for a basket of emerging market economy currencies or averages of bilateral US dollar estimates. Positive exchange rate values denote depreciation relative to the US dollar.
  - Country-specific and sample differences affect point estimates; example full sample and post-global financial crisis point estimates for Korea, Mexico, and Brazil are noted in the table.

_Italic: Source: onlineannex11_

---


_Source: https://www.imf.org/-/media/files/publications/gfsr/2020/october/english/onlineannex11.pdf_