Monetary Policy and the Short-Rate Disconnect in Emerging Economies

We document that central banks in emerging economies follow the Taylor rule, lowering policy rates when inflation is below average and during economic slowdowns. However, unlike in advanced economies, short-term market rates in many emerging economies do not always move together with policy rates, both on average and over the business cycle. This short-rate disconnect arises from the importance of external financing conditions for domestic market rates in emerging economies. Emerging economies whose banks rely more on external funding and face high external premiums are more likely to experience this disconnect, which reduces the efficacy of monetary policy.