Open economy codependence: US monetary policy and interest rate pass-through

We analyze the international transmission of interest rates under pegged and non-pegged exchange rate regimes, demonstrating that transmission depends upon the informational properties of a base country’s interest rate change. We differentiate between interest rate movements which are predictable/unpredictable and dependent/independent (i.e., a function of non-monetary factors such as cost-push inflation). Under capital mobility, we show that predictable or dependent interest rate changes should elicit interest rate pass-through for an imperfectly credible peg that is less than unity, whilst interest rate changes that are unpredictable and independent should elicit pass-through greater than unity. Using a real-time identification of unpredictable and independent U.S. federal funds rate changes, we provide evidence consistent with these propositions. When the federal funds rate change is unpredictable and independent, the joint hypothesis of unit within-month pass-through to pegs and zero within-month pass-through to non-pegs cannot be rejected. The same hypothesis is strongly rejected following actual, aggregate federal funds rate changes which include predictable and dependent components. In a dynamic context, we find that maximum interest rate pass-through to pegs is delayed. Moreover, even though there is a full transmission of unpredictable and independent federal funds rate changes, they explain only a small portion of pegged regime interest rate changes.