Where the Fed’s inflation crushing campaign could hurt the most

“There is certainly a fragility that could interact with tighter financial conditions in a way that could trigger a certain amount of stress, even in some fairly healthy emerging markets,” said Tobias Adrian, director of the money and markets department. of the capital of the International Monetary Fund.

As the custodian of the world’s reserve currency, the Fed has tremendous influence on global financial markets at a time when they are becoming increasingly tightly integrated. Monetary policies to slow inflation, such as rising financial costs, are mainly transmitted through these markets. As higher rates drive up the value of the dollar, debt held in US dollars anywhere in the world becomes more expensive to repay.

Fed rate hikes can also lead to large capital outflows from other countries as investors withdraw their money from emerging markets to get a better return in the US. This can have destabilizing effects on their economies.

New data released Wednesday shows emerging markets suffered a record high for the fifth consecutive month in which investors withdrew their money. The numbers, 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 crisis level. of the “taper tantrum” in 2013, when another Fed’s move to withdraw support for the US economy caused financial panic in some emerging markets.

Global economy administrators warn of extreme uncertainty as the Fed and other major central banks step up their moves to tighten financial conditions around the world to combat rising inflation. The IMF’s latest update on its global economic outlook revised inflation up to 6.6% in advanced economies and 9.5% in emerging markets, nearly a percentage point higher than previous forecasts.

According to the IMF, about 60 per cent of low-income countries are in or near debt distress. The amount of debt on which they could potentially default is $ 455.6 billion. If these countries were to default, this could mean difficulties as governments would not be able to provide support to a large swath of the world’s population.

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

“Global financial markets have grown substantially as have capital flows and the role of the United States in the global economy has somewhat diminished with the rise of China and other emerging markets,” said Mark Sobel, ex Treasury Officer and President of the United States in the Financial Institutions Forum’s Monetary and Think Tank Office.

The impact of Fed policies could be felt more in countries that are already battling high levels of inflation and tighter financial conditions due to domestic and global pressures. This includes Central and Eastern Europe and Sub-Saharan Africa, which are most affected by the shock of high commodity prices on fuel and food following the Russian war in Ukraine.

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

“When I look around the major emerging markets, the ones that are part of the G20, I see a lot of stability, with perhaps one or two exceptions,” said Adrian of the IMF, refusing to name specific countries.

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

However, the debt-to-GDP ratio continues to grow even in many economically stable countries, a worrying trend for global financial stability.

Nobody, however, expects the Fed to punch in its anti-inflation campaign for the benefit of the global economy unless it serves the interests of the United States.

“The Federal Reserve’s mandate is to provide price stability and full employment in the United States. Point by point, ”said Nathan Sheets, Citi’s chief global economist who previously served as Undersecretary of International Affairs at the Treasury and headed the Fed’s international division.

“This is the perspective from which they see the domestic economy but also the global economy”.

If the Fed does not provide economic and financial stability at home, the US risks becoming 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 provide that fundamental mandate,” Sheets said.

On the eve of the pandemic, Fed Chairman Jerome Powell acknowledged that the world’s leading central bank was “more acutely aware” of how its policies have affected other countries.

“Pursuing our national mandates in this new world requires that we understand the intended effects of these interconnections and incorporate them into our political decision-making,” he said in a 2019 speech.

This is an evolution of the 1980s, when then Fed Chairman Paul Volcker pushed interest rates to skyrocketing levels to skyrocket inflation in the United States and later admitted that “Africa wasn’t even on my radar screen “.

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

“What’s not really an example of is that the Fed made a political decision that was good for other economies but not for the United States,” said Steven Kamin, a senior fellow at the American Enterprise Institute who has served as head of the Fed’s international division from 2011 to 2020. “It will be nearly impossible to find such an example.”

Clearly communicate when rates might rise and set expectations about what the Fed’s best tool might be to avoid sending shockwaves around the world. This may be the main reason why his moves have not yet caused widespread crises in other countries.

The impact “is more limited than perhaps one would have expected from a historical sense, and I think this is due to the communication from the Fed,” said Sebnem Kalemli-Ozcan, an economics professor at the University of Maryland who studies impact of the Fed on emerging markets. “The Fed is now communicating very clearly.”