In the last Federal Open Market Committee meeting (29-30 July 2014) the board members signalled greater focus on monetary tightening. This to be achieved by gradual tapering of the five year long quantitative easing program accompanied by gradual increase of interest rates which are currently hovering around the zero lower bound.
The economy witnessed increases in non-farm employment, industrial production and capacity utilization in the second quarter. Inflation as measured by real personal consumption expenditure (PCE) increased indicating demand growth. These accompanied by optimistic business environment, reduction in fiscal deficit and improving trade balance led the board members to announce a reduction in purchase of Mortgage Backed Securities from $15 Billion to $10 Billion. Purchase of long term treasury securities are also set to decline to $15 Billion from $20 Billion.
Although the FED supports a dovish stance on raising interest rates immediately and the committee currently seeking reserve conditions aligned to the federal funds rate ranging between 0 and 25 bps, most analysts expect a rise in the interest rate by summer of 2015 and industry expectations are aligned accordingly.
In this context it is important to shed light on the operating forces behind hike in rates. If the same is driven by robust economic growth spurred by rising demand then the process generates positive spill-overs and will lead to higher interest rates at home and abroad.
In contrast, however, interest rate increases caused by instability in the financial markets will dampen foreign activity and lead to capital flight from other economies. An example of this is when back in 2012 the European Central Bank had to print over a trillion euros to currency to calm the distressed euro as investors flocked to sell euro denominated debt for US treasury securities.
The following graph illustrates the main causes of rate increase in the past year and traces it back to real shocks or demand generated hikes and money shocks or risk and panic driven hikes.
Thus as far as US and other advanced economies similarly progressing towards recovery are concerned, it is crucial to remain on the trajectory of self-sustaining growth and ensure that rate hikes are a consequence of robust economic growth.
With this in the background it is important to underscore the extent and magnitude of spill over effects of normalization of monetary policy vis-à-vis rate hikes and its impact on major financial instruments for emerging economies.
MSCI – Morgan Stanley Capital International Index, EMBI – Emerging Markets Bond Index
As depicted in the graphs above, ‘taper talks by the FED’ led to high fluctuations in foreign exchange rates and financial markets in emerging economies. With slowdown in growth rates in emerging countries post the great recession, spill over effects generated from policy normalization can have widespread implications.
The slower growth rate accompanied by higher expectations of long term interest rates in advanced economies can further reinforce the slowdown. One of the major consequences of higher long term rates as depicted above is fluctuating exchange rates and capital flight.
In the light of the above it is imperative for governments in emerging to economies to focus in developing strong fundamentals with attention on stimulating GDP growth, controlling inflation, developing an investment friendly business environment which attracts FDI, controlling the fiscal deficit and possibly controlling trade balances by hedging against currency risks.
For more details on spill over effects read the complete report published by the IMF
interesting
The inter-linkages of the economies are quite high. It would also be interesting to see how such policy changes affect, and how are they dealt with for economies like China.
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