Cracking the code to the global financial cycle
The dollar and financial cycle move together. Economists now think they know why
One of the best understood facts in international economics is that the dollar is at the centre of everything. Critical to trade and finance, the US currency affects every other economy and the Federal Reserve’s policy is transmitted worldwide via exchange rates. There is a well-documented link between the strength of the dollar and financial conditions worldwide – the global financial cycle. In the upward phase of the cycle, risky assets appreciate and credit conditions ease, while the dollar tends to depreciate.
But despite the clear correlation between the dollar and the global cycle, economists have struggled to pin down the causal mechanism. Numerous papers sought explanations in the bond markets, which are critical to the transmission of central bank policy and tend to be the epicentre of financial instability, but no compelling evidence emerged. Now, economists Hélène Rey, Vania Stavrakeva and Jenny Tang may have cracked the code, by looking in equity markets. “I don’t want to be overexcited, but I am quite excited,” Rey tells Central Banking. “I think we understand why. We didn’t before.”
London Business School's Professor Rey, has been laying the groundwork for this finding for some time. One of her best-known papers emphasises how the global financial cycle constrains national monetary policy regardless of the exchange rate regime, contrary to the implications of the well-known Mundell-Fleming model. And in a paper published in 2006 with Harald Hau, she showed exchange rate dynamics are tightly linked to equity market development.
Her latest paper explains how exchange rates can be expressed in terms of net equity supplies and elasticities representing the “centrality” of different currencies in the global system. Rey, Stavrakeva and Tang show it is possible to use data on mutual fund holdings to reconstruct almost all equity market movements, and in turn to reconstruct almost all exchange rate movements. This then allows them to show how US macroeconomic news and the vast financial firepower of US investors drives the global financial cycle.
For the full Central Banking article, Hélène Rey on cracking the code to the global financial cycle (October 10th 2024), click here
