The Monetary and Economic Department of the Bank of International Settlement (BIS) published a working paper assessing the issue of conducting a wise monetary policy in emerging countries. In particular, the focus is whether central banks in emerging markets should take systemic risk into account when making monetary policy decisions.

Since the Great Financial Crisis of 2007-09, policymakers needed to address financial risk concerns. Some commentators suggest that central banks should take account of financial risk in setting the policy rate. In particular, they propose “leaning against the wind”, by which central banks should raise interest rates when financial imbalances accumulate.

Research on “leaning against the wind” has concentrated on the experience of advanced economies. Little is known about the advisability of such policies in emerging markets, where capital flows are important contributors to financial imbalances. Results show that, in emerging markets, “leaning against the wind” considerations for conducting monetary policy are weakened. Higher interest rates attract additional capital flows, which in turn fuel domestic credit growth and the accumulation of financial imbalances.

In particular, results suggest a strong dependence of domestic financial conditions on capital flows, which diminishes the effectiveness of monetary policy to lean against the wind. Indeed, in the open-economy with endogenous financial crises, the optimal policy rate is even below the level that would prevail in the absence of endogenous financial crisis and systemic risk.

Financial and price stability in emerging markets: the role of the interest rate (PDF)