US Fed’s Monetary Policy Tightening To Pose Challenges For Emerging Markets

On January 17, 2022, the International Monetary Fund (IMF) published a blog regarding the fallout of the policy tightening measures that will be undertaken by the United States government. The international financial institution warned that the Federal Reserve’s decision to increase the policy rate would pose a challenge for the emerging economies of the world in the near future. IMF stated that the economic outlook already seems uncertain in emerging markets like India due to the new COVID-19 Omicron variant and high rates of inflation. The increase in the policy rate could result in a ripple effect in the global financial markets. The emerging economies are especially vulnerable to fluctuations like these.

Why is the US Federal Reserve Increasing the Policy Rates?

In early 2020, when the COVID-19 pandemic broke out, the forex market anticipated that the economic impact of the pandemic would be limited. However, we know now that the pandemic has put even the most advanced economies at risk. Investors in the United States were anticipating a temporary rise in inflation this year, given the slow opening of the supply bottlenecks and the unsteady post-lockdown economic recovery in 2021. However, that sentiment has undergone a drastic shift in recent times.

The raging inflation in the country hit a 40 year high in December 2021. Eager to control the rising inflation, many officials from the Federal Reserve have indicated that the increase in policy rates would have to be brought in soon. With the new COVID-19 Omicron variant, there is a growing concern about the pressures related to the supply side adding to inflation. These developments were the key reason behind the Federal Reserve’s decision to reduce the monthly pace of net asset purchases.

As the disruptions in supply ease and the fiscal contraction starts weighing on demand, it is expected that inflation will go back to moderate levels. In the past, the effects of the US policy rate increasing on the emerging markets were benign. However, this was the case when the policy tightening measures were well-announced and gradual.

The Effect of Policy Tightening Measures on Emerging Economies

The current policy tightening measures could result in rattling the emerging markets to a great degree. The resulting tightening of the financial conditions globally could result in the slowing of trade and demand in the United States. The result would be greater currency depreciation and capital outflows in the emerging markets. Vulnerable economies which have a high public and private debt, low current-account balances, and low foreign exchange (forex) exposure would experience larger movement in currencies. The IMF has highlighted in the recent report that the elevated vulnerability and slower growth in these countries could result in the formation of adverse feedback loops.

The outlook for these vulnerable countries remains very uncertain at present. It has been found that the average gross government debt in these markets has increased by around 10% since 2019. By the end of 2021, this had reached an estimated 64% of the gross domestic product (GDP). Unlike the United States, the labor markets in these countries are less robust and the economic recovery would also be difficult. However, the dollar borrowing cost for most countries would remain low. The concern is about the raising of interest rates. Last year, many markets like Brazil, South Africa, and Russia raised their interest rates due to problems in foreign funding and domestic inflation concerns.

How Should Emerging Markets Respond?

Many emerging economies have already started making adjustments in their foreign policies to address the rising inflation and debt. It is important for these economies to modify their response according to their vulnerabilities and circumstances. The countries that have credible policies for containing inflation should consider tightening their monetary policies at a slower pace and more gradually. However, those which face stronger pressures of inflation or have weaker institutions have to act quickly, although comprehensively.

In both cases, the responses should involve raising the benchmark interest rates and allowing the currencies to depreciate. If these economies are faced with problematic conditions in the forex markets, their respective central banks can intervene. However, this intervention should not be a substitute for macroeconomic adjustments.

Even with the aforementioned actions, the emerging markets will be faced with difficult choices. This is because they would have to safeguard price and external stability at the cost of supporting the weak domestic economy. The credit risks could increase markedly if these countries try to provide additional support to businesses beyond the existing measures. If they delay in recognizing their losses, it could result in the weakening of their financial institutions. Rolling these measures back, however, could tighten the financial conditions even more, thereby weakening the recovery.

Conclusion

The global pandemic has permanently altered the structure of the forex markets. However, it is expected that the global financial recovery will continue this year and into the next. The resurgent pandemic will continue to pose a risk to this economic recovery, and with the US Federal Reserve’s plan for policy tightening, it is important that the emerging economies are well-prepared for the economic turbulence.