Where the Fed’s anti-inflationary campaign could hurt the most

“There is certainly a fragility that could interact with tighter financial conditions in a way that could trigger some level of stress, even in some fairly healthy emerging markets,” said Tobias Adrian, director of the International Monetary Fund’s Department of Money and Capital Markets .

As manager of the world’s reserve currency, the Fed wields massive influence over global financial markets at a time when they are becoming increasingly integrated. Monetary policy measures to slow inflation, such as B. the increase in the cost of credit, are mainly transmitted through these markets. As higher interest rates push up the value of the dollar, paying off debt denominated in US dollars becomes more expensive around the world.

The Fed’s interest rate hikes can also lead to significant capital outflows from other countries as investors pull their money out of emerging markets in search of a better yield in the US. This can have destabilizing effects on their economies.

New data was released on Wednesday shows that emerging markets suffered a record-breaking fifth straight month of investors withdrawing their money. The figures, compiled monthly by the Institute of International Finance, a trade group for the global financial services industry, show that capital flight — totaling $39.3 billion since March — is reaching the level of the “taper tantrum” crisis of 2013, The Fed’s move to withdraw support for the US economy sparked financial panic in some emerging markets.

Global economic stewards are warning of extreme uncertainty as the Fed and other major central banks accelerate moves to tighten financial conditions around the world to combat rising inflation. The IMF’s latest update on its global economic outlook revised inflation to 6.6 percent in advanced economies and 9.5 percent in emerging markets – almost a full percentage point higher than previously forecast.

According to the IMF, around 60 percent of low-income countries are in a debt crisis or are about to be. The amount of debt they could potentially default on totals $455.6 billion. A default by these countries could mean an emergency as governments would be unable to support large sections of the world’s population.

But former officials and pundits say the shape of a potential Fed-induced global debt crisis looks different than it did in the 1980s, when rate hikes sent many economies into collapse.

“Global financial markets have grown significantly, as have capital flows, and the U.S. role in the global economy has declined somewhat with the rise of China and other emerging economies,” said Mark Sobel, a former Treasury Department official and U.S. chair at Official Monetary and Think Tank of the Financial Institutions Forum.

The impact of Fed policy is likely to be felt most strongly in countries that are already struggling with high inflation rates and tightening financial conditions due to domestic and global stresses. This includes Central and Eastern Europe and sub-Saharan Africa, which have been hit hardest by the shock of high commodity prices for fuel and food resulting from the Russian war in Ukraine.

Large emerging markets such as Brazil, China and India could be less affected by the Fed’s actions.

“If I look around at the big emerging economies that are part of the G20, I see a lot of stability, with maybe one or two exceptions,” said Adrian of the IMF, without naming specific countries.

Central banks in many major emerging markets have more credibility than they did decades ago because their policies are more data-driven and independent of political interference. Many countries are also now holding more foreign exchange reserves or have less debt denominated in foreign currencies such as the US dollar, leaving them less exposed to debt in other currencies.

Nevertheless, even in many economically stable countries, the debt ratio continues to rise – a worrying trend for global financial stability.

Nobody expects, however, that the Fed will crack down on its anti-inflation campaign in favor of the global economy unless it serves US interests.

“The Federal Reserve’s mandate is to maintain price stability and full employment in the United States. Period,” said Nathan Sheets, Citi’s chief global economist, who was formerly the undersecretary for international affairs at the Treasury Department and head of the Fed’s international division.

“That’s the perspective from which they look at the domestic economy, but also the global economy.”

If the Fed doesn’t provide economic and financial stability at home, the US could become a source of instability for the rest of the world, he said.

“Ultimately, the best way to support the rest of the world is to fulfill that core mandate,” Sheets said.

On the eve of the pandemic, Fed Chair Jerome Powell acknowledged that the world’s main central bank is “more aware” of how its policies affect other countries.

“Following our national mandates in this new world requires that we understand the expected implications of these connections and incorporate them into our policy-making,” he said in a 2019 speech.

That’s been a development since the 1980s, when then-Fed Chairman Paul Volcker ratcheted up interest rates to dizzying heights to bring down sky-high US inflation — later admitting that “Africa wasn’t even on my radar screen.”

But there are few examples where the Fed has held back monetary policy decisions, such as rate hikes, due to global events. The central bank shelved an expected increase in 2015 and early 2016 due to the market turmoil in China. But the rate hikes at this point may have had a negative impact on the US economy.

“It’s not really an example of the Fed making a policy decision that was good for other economies but not good for the United States,” said Steven Kamin, a senior fellow at the American Enterprise Institute who serves as head of the international department the Fed functioned from 2011 to 2020. “It will be almost impossible to find such an example.”

Communicating clearly when it might hike rates and setting expectations about how much might be the Fed’s best tool to avoid sending shockwaves around the world. That may be the main reason why his moves have not yet resulted in widespread crises in other countries.

The impact “is more limited than might have been expected from a historical perspective, and I think that’s because of the Fed’s announcement,” said Sebnem Kalemli-Ozcan, an economics professor at the University of Maryland who studies the Fed’s impact on emerging markets. “The Fed is now communicating very clearly.”

Where the Fed’s anti-inflationary campaign could hurt the most

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