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Janet Yellen should pay more heed to international risks

Janet Yellen should pay more heed to international risks

Fed chairman’s testimony should have been more cautious 

by Desmond Lachman

Mon 17 Feb 2014

In her congressional debut as Federal Reserve chair, Janet Yellen last week gave short shrift to the notion that international economic developments should be a major concern to the Fed as it continues to taper its bond-buying programme.

She risks repeating the mistake of Ben Bernanke, her predecessor, who at the start of his tenure in 2006 greatly underestimated the impact of the imminent bursting of the US housing bubble on US and global economies. Recent developments in key areas of the world are signalling that the international economy could constitute a major headwind to the US recovery before the year is out.

Yellen’s dismissal of the emerging markets as a threat to the US recovery seemingly pays scant heed to the emerging economies’ roughly 50% share of the global economy. There are signs of slower Chinese growth. And there are still potentially disturbing economic and political developments in Europe’s periphery.

The confluence of difficulties across a wide swathe of the global economy should be giving Yellen pause. This could have serious consequences for US and global financial markets that could have an important bearing on US growth.

It is imprudent for Yellen to base Fed policy on wishful thinking about the international environment. Alerting Congress to the undoubted risks would make it easier for the Fed to reverse course on tapering if required by global developments.

Since May 2013, when Bernanke first floated the idea about Fed tapering, a number of key emerging economies have come under severe market pressure, with earlier massive capital inflows partly reversed. Markets focused attention on these countries’ large domestic and external imbalances. This led to a 10-20% currency weakening in Brazil, India, Indonesia, South Africa and Turkey over the past nine months.

In response to this weakening, these countries have had to raise interest rates in an effort to curb the inflationary impact.

The immediate economic growth outlook of the so-called 'Fragile Five' does not appear promising. According to a World Bank study, a 1 percentage point increase in US long-term interest rates as a result of Fed tapering could reduce capital flows to the emerging markets by as much as 50%. In each of those countries, contentious presidential or parliamentary elections are due in the next few months. This makes it politically difficult for those countries to adopt the right economic policies to keep inflation under control.

Another potentially negative factor is China’s economic outlook. Even in the event of a soft landing, Chinese growth is expected to slow, providing a less favourable environment for emerging markets than hitherto.

Yellen’s Fed faces considerable risks. Last week’s statement failed adequately to spell them out.

Desmond Lachman is Resident Fellow at the American Enterprise Institute (AEI). He was formerly Deputy Director in the IMF’s Policy Development and Review Department and Chief Emerging Market Economic Strategist at Salomon Smith Barney.

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