Monetary Policy and the Short-Rate Disconnect in Emerging Economies

We find that central banks in emerging economies with floating exchange rates follow the Taylor-rule and lower policy rates during economic slowdowns, indicating a counter-cyclical monetary policy stance. However, unlike in advanced economies, short-term market rates in many emerging economies do not always move together with policy rates; while policy rates are pro-cyclical, market rates are often counter-cyclical. This short-rate disconnect arises from the greater importance of external financing conditions for domestic market rates in emerging economies. Emerging economies whose banks rely more on external funding and face high external premiums are more likely to experience this disconnect, which reduces the efficacy of monetary policy.