When Policy Bites

We document the state-dependence of monetary policy transmission to output and core consumer prices in a sample of eleven large inflation-targeting emerging markets along three cyclical dimensions: the business cycle position, the monetary policy stance, and the level of trend inflation. We show that monetary policy has strong effects on output during recessions and after a period of loose monetary policy, but little to no impact during expansions or when monetary policy has been tight. In contrast, the response of prices is muted regardless of business cycle position or monetary policy stance. Transmission also depends on trend inflation: when trend inflation is low, monetary policy has a stronger impact on output and a weaker effect on prices, whereas a high-inflation environment dampens the output response and amplifies price adjustments. These findings are broadly consistent with the presence of financial frictions in the form of occasionally binding borrowing constraints, endogenous frequency of price adjustments, loss aversion preferences, and a convex Phillips Curve.