The Bank of England published a staff working paper by Ambrogio Cesa-Bianchi, Andrea Ferrero and Shangshang Li assessing the “dilemma” hypothesis on the international transmission of US monetary policy. The paper finds that, following an unanticipated US tightening, the demand and financial channel dominates expenditure switching, so that a typical small open economy experiences higher credit spreads and falling real GDP and exports despite a currency depreciation. Empirically, an estimated panel VARX using monthly data for 15 economies classified as having the highest exchange-rate flexibility over 1997–2019 shows domestic spreads co-move with US spreads and real activity and exports decline even when the exchange rate depreciates, while CPI inflation and the policy rate response are muted. A two-country open-economy model is estimated to match these impulse responses and attributes the results to financial and pricing frictions that give a prominent role to the global reserve currency; counterfactuals highlight the importance of trade pricing frictions (including local-currency pricing and importer price stickiness) and imperfect pass-through in shaping export and inflation dynamics. Model-based policy experiments suggest the exchange rate regime still matters, with greater exchange-rate stabilisation in the monetary policy rule increasing output and inflation volatility, while countercyclical instruments targeting domestic credit or capital flows can dampen fluctuations; under a fixed exchange rate, either instrument can reduce negative spillovers on real activity but not on inflation. The working paper is presented as research in progress intended to elicit comments and debate, and the views expressed are those of the authors rather than Bank of England policy.
Bank of England 2025-09-19
Bank of England staff paper finds US monetary tightening raises spreads and cuts exports even as small economies’ currencies depreciate
The Bank of England released a paper examining the "dilemma" hypothesis on US monetary policy's international effects. It finds US monetary tightening raises credit spreads and reduces real GDP and exports in small open economies, despite currency depreciation. The paper highlights financial and pricing frictions and suggests exchange rate regimes and countercyclical instruments can influence economic volatility.