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By Mehdi Farooq 26-02-2020

How Fed Policy Determines Global Capital Flows

(7 min read)
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When the US economy sneezes, every other country catches a cold. Many investors have long felt this, and in recent years academics have provided the empirical support for this notion. One of the central pieces in this literature is London Business School professor Hélène Rey’s paper Dilemma, not Trilemma: The global financial cycle and monetary policy independence. She finds that the global credit and capital flow cycle is dominated by US monetary policy, which can overwhelm local factors in other countries. This has important policy and market implications.

3 Key Observations

In her paper, she makes the following observations:

• International capital flows are highly correlated

Rey finds a strong commonality in capital inflows across asset classes, whether FDI, equities, bonds or credit. The heatmap below shows a matrix of correlations of flows into these assets across various regions for the period 1990 to 2012. The sea of green shows the predominance of positive correlations, which implies a global common factor. A similar result is found for capital outflows.

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