Christian Friedrich, Pierre Guerin and Danilo Leiva
We propose a new strength measure of the global financial cycle by estimating a regime-switching factor model on cross-border equity flows. We then assess how this measure affects monetary policy independence, defined as central banks’ responses to exogenous changes in inflation. We show that central banks tighten their policy rates in response to an unanticipated increase in inflation during times when global financial cycle strength is low, but their responses are muted when financial cycle strength is high. Finally, we show that capital controls, macroprudential policies, and a flexible exchange rate regime can increase monetary policy independence.