## Normalization of Global Financial Conditions: The Implications for Brazil — Section 1

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---

### Introduction
- May 2013 taper announcement revealed potential challenges for emerging markets, including Brazil (Bernanke testimony on May 22, 2013).
- Market reactions during the taper episode:
  - U.S. 10-year Treasury yields rose by about 100 basis points during the summer of 2013.
  - By end-August 2013, Brazilian 10-year Government bond yields had risen by more than 200 basis points.
  - The real had depreciated by around 15 percent against the U.S. dollar.
  - Brazil’s central bank raised its benchmark interest rate by 150 basis points between the taper speech and end-August 2013.
- Key diagnostic: distinguish tightening of financial conditions due to better economic prospects versus monetary developments (uncertainty about monetary policy), because transmission and spillovers differ.

### Why did Long-Rates Rise in the U.S.?
- Two interpretable drivers of the rise in U.S. long-term yields:
  - Monetary shocks: uncertainty about the future course of monetary policy (tightening money shocks raise yields and depress stock prices).
  - Economic news shocks: better economic prospects (raise both yields and stock prices).
- Taper episode dynamics:
  - Monetary shocks dominated immediately after the taper announcement, adding about 20 basis points to the U.S. 10-year yield in May 2013 and another 30 basis points after the June 2013 FOMC.
  - Monetary shocks accounted for the majority of the ~100 basis points rise in 10-year yields since May 2013 prior to the September 2013 FOMC clarification.
  - The December 2013 announcement confirming tapering for 2014 had little impact on yields and was perceived as confirmation of taper due to improving economic outlook.
- Fed communications evolution:
  - Under Chair Janet Yellen (confirmed early 2014) communications improved and were increasingly perceived as more “dovish” than under Ben Bernanke.
  - End of asset purchases in October 2014 was widely anticipated; markets expected a rise in the Fed Funds rate “in ernest during 2015.”
  - These improved communications reduced the impact of monetary shocks on long rates and exerted downward pressure on long rates since mid-2014.

### Methodology
- Empirical approach treats U.S. developments as exogenous to Brazil.
- Two-step strategy:
  - Identify historical U.S. 10-year bond yield contributions from monetary shocks and economic news shocks using a sign-restricted VAR estimated at the daily frequency.
  - Feed these identified U.S. shocks into a monthly Brazilian VAR (late 2006 start) to assess differentiated effects on Brazil.
- Brazilian VAR includes: central bank’s real economic activity index, policy interest rate, 10-year government bond yield, CPI, nominal exchange rate vs. U.S. dollar, and business confidence.
- Model specifics:
  - Natural logarithm taken of each variable prior to estimation except interest rates (left in levels).
  - Model includes one lag of all variables (Schwarz-Bayesian criterion).
  - Assumption: U.S. developments can affect Brazilian variables contemporaneously (within a month) and with lags; Brazilian variables do not affect U.S. variables.
  - Sample limited because Brazil began issuing 10-year government bonds in late 2006.

### Results — Impact on Brazil of a 100 basis point U.S. 10-year Yield Increase
- Simulation setup:
  - Responses shown for a 100 basis point increase in the U.S. 10-year yield driven either by a monetary shock or a news shock.
  - Model simulated 1,000 times; bars show average 6-month responses; lines show standard deviation of averages.
  - Confidence bands wide due to small sample.
- Interest rate responses (average over six months):
  - If the U.S. 100 basis point increase is due to a monetary shock:
    - Brazilian policy rate increases by around 80 basis points.
    - Brazilian long-rate increases by around 200 basis points (yield curve steepens).
  - If the U.S. 100 basis point increase is due to positive economic news:
    - Brazilian policy rate increases by around 100 basis points.
    - Brazilian long-rate increases by around 100 basis points (yield curve slope broadly unchanged).
  - Averaging economic news and monetary shocks:
    - U.S. 100 basis point rise leads to Brazil 10-year yield rise of around 150 basis points.
  - Weekly-frequency smaller model including only U.S. shocks and Brazilian long rate yields similar results to baseline.
- Real economy and exchange rate:
  - U.S. monetary shock:
    - Depreciates Brazilian nominal exchange rate against the U.S. dollar.
    - Reduces Brazilian economic activity and business confidence.
  - U.S. positive economic news shock:
    - Appreciates Brazilian nominal exchange rate against the U.S. dollar.
    - Increases Brazilian activity and business confidence.
    - Puts upward pressure on Brazilian prices.
- Variance decomposition highlights:
  - Short horizons: domestic developments drive a significant share of forecast error variance of Brazil’s policy rate.
  - After one year: U.S. developments—especially economic news shocks—account for more than ¾ of the variance of the policy rate.
  - Brazilian long-rate: forecast error variance impacted almost immediately by U.S. monetary shocks; positive economic news becomes increasingly important over time.
  - Exchange rate, output, CPI, business confidence: domestic shocks are more important drivers than U.S. shocks, suggesting financial linkages are tighter than trade/activity linkages.
  - Nominal exchange rate being more driven by domestic factors may reflect domestic fundamentals and a risk premium; interpretation cautioned due to structural assumptions in the VAR.
- Post-taper (since April 2013) contributions to cumulated changes:
  - Positive U.S. economic developments significantly contributed to the rise in Brazilian interest rates.
  - Monetary shocks had an important positive impact on long-term yields immediately after the taper episode; that effect began unwinding by end-summer 2013.
  - Positive U.S. economic news then became the most important driver of long-term yields; domestic developments (possibly perceptions about country risk) also became more important in late 2013 and early 2014.
  - Exchange rate dynamics:
    - Initial sharp depreciation following taper episode due to U.S. monetary shocks and negative domestic developments.
    - Partial recovery after central bank’s FX intervention program announcement in August 2013.
  - Activity, prices, and confidence:
    - Benefited from better U.S. economic news, but largely offset by deteriorating domestic conditions.
    - From mid-2013 to mid-2014, consensus growth forecasts for 2014 fell by around 1.5 percent to just over 1 percent.
    - Inflation expectations rose by around 0.5 percent, close to the ceiling of the tolerance region around the target.

### Why are Brazilian Interest Rates So Responsive to U.S. Developments?
- Fundamentals matter for dampening responses to money shocks.
- IMF (2014) evidence: emerging economies with relatively strong fundamentals experienced smaller reactions to rising U.S. long-term yields.
- Key fundamentals that mitigate spillovers:
  - higher reserves,
  - lower inflation,
  - higher current account balance,
  - deeper financial markets,
  - stronger underlying growth.
- Conclusion: deteriorating domestic fundamentals in Brazil have contributed to heightened responsiveness of Brazilian yields relative to other emerging economies.

### Conclusion and Policy Implications (Section 1 summary)
- Monetary policy normalization is a healthy global development when driven by improved economic prospects, but uncertainty about the future course of monetary policy can cause adverse spillovers (as in the taper episode).
- Correctly diagnosing the source of tighter global financial conditions (monetary uncertainty vs. better economic prospects) is crucial for Brazil’s policy response.
- Adverse spillovers can be mitigated by strengthening policy frameworks and fundamentals (reserves, inflation control, current account, financial depth, growth), which reduce sensitivity to U.S. monetary shocks.

---

### CONCLUSION AND POLICY IMPLICATIONS — Section 2

### Overall assessment
- As economic prospects in the U.S. continue to improve, financial conditions are expected to normalize in a smooth fashion.
- Overall, recovery in the U.S. is beneficial to the global economy and Brazil.
- The tapering episode highlighted that potential challenges may arise going forward.

### Central bank objectives and communication
- Central banks’ objectives have become more complex, giving rise to communication challenges, and the potential for further bouts of market volatility.
- Following the global financial crisis, central banks have become more mindful of the tradeoff between financial stability and price stability.
- This potential conflict in objectives is amplified by the need to manage the multiple instruments (policy rates and balance sheets), adding to the complexity of policy communication going forward, and raising the specter of further bouts of uncertainty and market volatility.

### Diagnosis and appropriate policy responses
- Appropriate policy responses depend on the underlying drivers of tighter financial conditions.
- Empirical results suggest:
  - Positive global economic developments will put upward pressure on interest rates, and cause nominal exchange rate appreciation and output gains.
  - Money shocks will trigger nominal exchange rate depreciation and output losses.
- Getting the correct diagnosis of tighter global financial conditions is critical to choosing the best policy course.

### Role of policy frameworks and fundamentals
- Sound policy frameworks and fundamentals can mitigate spillovers.
- Better understanding the role of policy credibility and sound fundamentals in the transmission of global shocks will improve economic policy, especially monetary policy.
- Spillovers from money shocks have typically been milder in countries with sound policy frameworks and fundamentals.
- Spillovers could also be amplified if a lack of credibility hinders the ability to respond to global shocks.

### Key empirical notes and figure highlights
- Figure 3: Impact of Money and News Shocks (average over six months, shocks increase US10 year bond yield by 100bps). Source: Staff estimates.
- Figure 4: Impact on Brazilian Long Rate: Baseline and Weekly Model (Average over six months, shocks increase U.S. 10 year bond yield by 100bps). Source: Fund staff estimates.
- Figure 5: Explanatory Power of Different Shocks at Different Horizons (months 1–12) across variables: Policy Rate, Long Rate, Exchange Rate, Output, Price, Business Confidence. Source: Fund staff estimates.
- Figure 6: Brazil: Cumulated Changes since Taper Episode and Contributions across: Policy Rate (In percent), Long Rate (In percent), Exchange Rate (In percentage change), Output (In percentage change), Prices (In percentage change), Business Confidence (In percentage change). Source: Fund staff estimates.

### Appendix: Data (as used in the empirical work)
- United States (Daily Data)
  - 10-year Treasury Yield at Constant Maturity (Board of Governors of the Federal Reserve System)
  - S&P 500 Index (The New York Times)
- Brazil (Monthly Data)
  - SELIC Target Interest Rate (Banco Central do Brasil)
  - 10-year Government Bond Yield (Haver)
  - Nominal Exchange Rate, reias/dollar (Banco Central do Brasil)
  - Economic Activity Indicator, seasonally adjusted (Banco Central do Brasil)
  - Extended National CPI, seasonally adjusted (Instituto Brasileiro de Geografia e Estatística)
  - Business Confidence Index, seasonally adjusted (Confederaçâo Nacional da Indústria)

*Source: Troy Matheson, "Normalization of Global Financial Conditions: The Implications for Brazil," IMF Working Paper WP/15/194, June 2015.*

### Section 1

### Normalization of Global Financial Conditions: The Implications for Brazil — Section 1

### Introduction
- May 2013 taper announcement revealed potential challenges for emerging markets, including Brazil (Bernanke testimony on May 22, 2013).
- Market reactions during the taper episode:
  - U.S. 10-year Treasury yields rose by about 100 basis points during the summer of 2013.
  - By end-August 2013, Brazilian 10-year Government bond yields had risen by more than 200 basis points.
  - The real had depreciated by around 15 percent against the U.S. dollar.
  - Brazil’s central bank raised its benchmark interest rate by 150 basis points between the taper speech and end-August 2013.
- Key diagnostic: distinguish tightening of financial conditions due to better economic prospects versus monetary developments (uncertainty about monetary policy), because transmission and spillovers differ.

### Why did Long-Rates Rise in the U.S.?
- Two interpretable drivers of the rise in U.S. long-term yields:
  - Monetary shocks: uncertainty about the future course of monetary policy (tightening money shocks raise yields and depress stock prices).
  - Economic news shocks: better economic prospects (raise both yields and stock prices).
- Taper episode dynamics:
  - Monetary shocks dominated immediately after the taper announcement, adding about 20 basis points to the U.S. 10-year yield in May 2013 and another 30 basis points after the June 2013 FOMC.
  - Monetary shocks accounted for the majority of the ~100 basis points rise in 10-year yields since May 2013 prior to the September 2013 FOMC clarification.
  - The December 2013 announcement confirming tapering for 2014 had little impact on yields and was perceived as confirmation of taper due to improving economic outlook.
- Fed communications evolution:
  - Under Chair Janet Yellen (confirmed early 2014) communications improved and were increasingly perceived as more “dovish” than under Ben Bernanke.
  - End of asset purchases in October 2014 was widely anticipated; markets expected a rise in the Fed Funds rate “in ernest during 2015.”
  - These improved communications reduced the impact of monetary shocks on long rates and exerted downward pressure on long rates since mid-2014.

### Methodology
- Empirical approach treats U.S. developments as exogenous to Brazil.
- Two-step strategy:
  - Identify historical U.S. 10-year bond yield contributions from monetary shocks and economic news shocks using a sign-restricted VAR estimated at the daily frequency.
  - Feed these identified U.S. shocks into a monthly Brazilian VAR (late 2006 start) to assess differentiated effects on Brazil.
- Brazilian VAR includes: central bank’s real economic activity index, policy interest rate, 10-year government bond yield, CPI, nominal exchange rate vs. U.S. dollar, and business confidence.
- Model specifics:
  - Natural logarithm taken of each variable prior to estimation except interest rates (left in levels).
  - Model includes one lag of all variables (Schwarz-Bayesian criterion).
  - Assumption: U.S. developments can affect Brazilian variables contemporaneously (within a month) and with lags; Brazilian variables do not affect U.S. variables.
  - Sample limited because Brazil began issuing 10-year government bonds in late 2006.

### Results — Impact on Brazil of a 100 basis point U.S. 10-year Yield Increase
- General simulation setup:
  - Responses shown for a 100 basis point increase in the U.S. 10-year yield driven either by a monetary shock or a news shock.
  - Model simulated 1,000 times; bars show average 6-month responses; lines show standard deviation of averages.
  - Confidence bands wide due to small sample.
- Interest rate responses:
  - Regardless of shock type, Brazil’s policy rate and 10-year yield rise by quantitatively significant amounts.
  - If U.S. 100 basis point increase is due to a monetary shock:
    - Brazilian policy rate increases by around 80 basis points.
    - Brazilian long-rate increases by around 200 basis points (yield curve steepens).
  - If U.S. 100 basis point increase is due to positive economic news:
    - Brazilian policy rate increases by around 100 basis points.
    - Brazilian long-rate increases by around 100 basis points (yield curve slope broadly unchanged).
  - Averaging economic news and monetary shocks: U.S. 100 basis point rise leads to Brazil 10-year yield rise of around 150 basis points.
  - Weekly-frequency smaller model including only U.S. shocks and Brazilian long rate yields similar results to baseline.
- Real economy and exchange rate:
  - Monetary shock (U.S.):
    - Depreciates Brazilian nominal exchange rate against the U.S. dollar.
    - Reduces Brazilian economic activity and business confidence.
  - Positive economic news shock (U.S.):
    - Appreciates Brazilian nominal exchange rate against the U.S. dollar.
    - Increases Brazilian activity and business confidence.
    - Puts upward pressure on Brazilian prices.
- Variance decomposition (Figure 5 insights):
  - Short horizons: domestic developments drive a significant share of forecast error variance of Brazil’s policy rate.
  - After one year: U.S. developments—especially economic news shocks—account for more than ¾ of the variance of the policy rate.
  - Brazilian long-rate: forecast error variance impacted almost immediately by U.S. monetary shocks; positive economic news becomes increasingly important over time.
  - Exchange rate, output, CPI, business confidence: domestic shocks are more important drivers than U.S. shocks, suggesting financial linkages are tighter than trade/activity linkages.
  - Nominal exchange rate being more driven by domestic factors may reflect domestic fundamentals and a risk premium; interpretation cautioned due to structural assumptions in the VAR.
- Post-taper (since April 2013) contributions to cumulated changes:
  - Positive U.S. economic developments significantly contributed to the rise in Brazilian interest rates.
  - Monetary shocks had an important positive impact on long-term yields immediately after the taper episode; that effect began unwinding by end-summer 2013.
  - Positive U.S. economic news then became the most important driver of long-term yields; domestic developments (possibly perceptions about country risk) also became more important in late 2013 and early 2014.
  - Exchange rate dynamics:
    - Initial sharp depreciation following taper episode due to U.S. monetary shocks and negative domestic developments.
    - Partial recovery after central bank’s FX intervention program announcement in August 2013.
  - Activity, prices, and confidence:
    - Benefited from better U.S. economic news, but largely offset by deteriorating domestic conditions.
    - From mid-2013 to mid-2014, consensus growth forecasts for 2014 fell by around 1.5 percent to just over 1 percent.
    - Inflation expectations rose by around 0.5 percent, close to the ceiling of the tolerance region around the target.

### Why are Brazilian Interest Rates So Responsive to U.S. Developments?
- Fundamentals matter for dampening responses to money shocks.
- IMF (2014) evidence: emerging economies with relatively strong fundamentals experienced smaller reactions to rising U.S. long-term yields.
- Key fundamentals that mitigate spillovers: higher reserves, lower inflation, higher current account balance, deeper financial markets, stronger underlying growth.
- Conclusion drawn: deteriorating domestic fundamentals in Brazil have contributed to heightened responsiveness of Brazilian yields relative to other emerging economies.

### Conclusion and Policy Implications
- Monetary policy normalization is a healthy global development when driven by improved economic prospects, but uncertainty about the future course of monetary policy can cause adverse spillovers (as in the taper episode).
- Correctly diagnosing the source of tighter global financial conditions (monetary uncertainty vs. better economic prospects) is crucial for Brazil’s policy response.
- Adverse spillovers can be mitigated by strengthening policy frameworks and fundamentals (reserves, inflation control, current account, financial depth, growth), which reduce sensitivity to U.S. monetary shocks.

*Source: Troy Matheson, "Normalization of Global Financial Conditions: The Implications for Brazil," IMF Working Paper WP/15/194, June 2015.*

### Section 2

### CONCLUSION AND POLICY IMPLICATIONS

### Overall assessment
- As economic prospects in the U.S. continue to improve, financial conditions are expected to normalize in a smooth fashion.
- Overall, recovery in the U.S. is beneficial to the global economy and Brazil.
- The tapering episode highlighted that potential challenges may arise going forward.

### Central bank objectives and communication
- Central banks’ objectives have become more complex, giving rise to communication challenges, and the potential for further bouts of market volatility.
- Following the global financial crisis, central banks have become more mindful of the tradeoff between financial stability and price stability.
- This potential conflict in objectives is amplified by the need to manage the multiple instruments (policy rates and balance sheets), adding to the complexity of policy communication going forward, and raising the specter of further bouts of uncertainty and market volatility.

### Diagnosis and appropriate policy responses
- The appropriate policy responses will depend on the underlying drivers of tighter financial conditions.
- The results suggest that:
  - Positive global economic developments will put upward pressure on interest rates, and cause nominal exchange rate appreciation and output gains.
  - Money shocks will trigger nominal exchange rate depreciation and output losses.
- Getting the correct diagnosis of tighter global financial conditions is critical to choosing the best policy course.

### Role of policy frameworks and fundamentals
- Sound policy frameworks and fundamentals can mitigate spillovers.
- Better understanding the role of policy credibility and sound fundamentals in the transmission of global shocks will improve economic policy, especially monetary policy.
- Spillovers from money shocks have typically been milder in countries with sound policy frameworks and fundamentals.
- Spillovers could also be amplified if a lack of credibility hinders the ability to respond to global shocks.

### Key empirical notes and figure highlights
- Figure 3: Impact of Money and News Shocks (average over six months, shocks increase US10 year bond yield by 100bps). Source: Staff estimates.
- Figure 4: Impact on Brazilian Long Rate: Baseline and Weekly Model (Average over six months, shocks increase U.S. 10 year bond yield by 100bps). Source: Fund staff estimates.
- Figure 5: Explanatory Power of Different Shocks at Different Horizons (months 1–12) across variables: Policy Rate, Long Rate, Exchange Rate, Output, Price, Business Confidence. Source: Fund staff estimates.
- Figure 6: Brazil: Cumulated Changes since Taper Episode and Contributions across: Policy Rate (In percent), Long Rate (In percent), Exchange Rate (In percentage change), Output (In percentage change), Prices (In percentage change), Business Confidence (In percentage change). Source: Fund staff estimates.

### Appendix: Data (as used in the empirical work)
- United States (Daily Data)
  - 10-year Treasury Yield at Constant Maturity (Board of Governors of the Federal Reserve System)
  - S&P 500 Index (The New York Times)
- Brazil (Monthly Data)
  - SELIC Target Interest Rate (Banco Central do Brasil)
  - 10-year Government Bond Yield (Haver)
  - Nominal Exchange Rate, reias/dollar (Banco Central do Brasil)
  - Economic Activity Indicator, seasonally adjusted (Banco Central do Brasil)
  - Extended National CPI, seasonally adjusted (Instituto Brasileiro de Geografia e Estatística)
  - Business Confidence Index, seasonally adjusted (Confederaçâo Nacional da Indústria)

### Select references cited
- International Monetary Fund, 2013, “Global Financial Stability Report,” Available via the intranet at https://www.imf.org/External/Pubs/FT/GFSR/2013/02/index.htm
- Kamil, Herman, Carlos Góes, Phil de Imus, Mercedes Garcia-Escribano, Roberto Perrelli, Shaun K. Roache, and Jeremy Zook, 2015, “The Effect of U.S. Monetary Normalization on Emerging Markets' Sovereign Bond Yields: The Different Cases of Brazil and Mexico,” IMF Working Paper, forthcoming.
- Matheson, Troy, and Emil Stavrev, 2014, “News and Monetary Shocks at a High Frequency: A Simple Approach,” Economics Letters, Volume 125 Issue 2, pp. 282−86.
- International Monetary Fund, 2014, “Spillover Report,” IMF Multilateral Policy Issues Report, pp. 27–57. Available via the Intranet at http://www.imf.org/external/np/pp/eng/2014/062514.pdf

*Source: _wp15194 - Section 2*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2015/_wp15194.pdf_