Fed hike signals monetary inflection point
Fiscal boost and pricier oil set scene for more rate hikes
by Danae Kyriakopoulou in London
Thu 15 Dec 2016
The Federal Reserve’s widely expected decision to increase the federal funds rate by 25 basis points yesterday marks an important step into what OMFIF called a ‘point of inflection’ from monetary to fiscal policy in the October edition of our monthly Bulletin.
Resuming a tightening path that began with former Chair Ben Bernanke’s ‘taper tantrum’ in 2013 but paused in 2016, the Fed joins other major central banks in scaling back the extraordinarily loose and unconventional monetary measures adopted in the wake of the Great Recession. The Bank of Japan’s decision to refrain from a rate cut and introduce yield curve controls in asset purchases in September, for example, confirms a shift to a more flexible approach.
Similarly, the European Central Bank’s decision on 8 December to trim the scale of monthly asset purchases from €80bn to €60bn reflects a belief by the Governing Council that the alarm deflation conditions that led it to up-size the programme in March 2016 have largely disappeared. The Bank of England may soon have to follow suit. Annual consumer price inflation reached a two-year high of 1.2% on the latest data released this week. Inflation expectations in the BoE’s quarterly inflation report from November suggest that, without tightening, inflation could rise sharply above the 2% target within the next six months.
Unlike the UK, where a key factor driving inflation is sterling depreciation, the Fed is facing increasing price pressures in spite of the trajectory of its currency. The strength of the labour market, consumer confidence, and the prospect of fiscal stimulus are bringing the economy close to overheating. Inflationary pressures will be further exacerbated by rising energy prices as the latest decision by Opec sets the scene for rising oil prices next year. More rate hikes are a certainty, if the Fed is not to fall behind the curve and face an overshooting of its target.
This shift to tightening from major central banks risks generating a perfect storm for emerging markets, adding to existing headwinds such as a continued slowdown in China, further renminbi devaluation, a move to trade protectionism, and rising geopolitical uncertainty. Economies with high exposure to US trade, as well as those with high levels of dollar-denominated debt, are particularly vulnerable to increasing trade barriers and further Fed tightening. Foreign exchange reserves may partly cushion the impact of sudden capital outflows. That said, as the experiences of Russia in 2014 and China more recently show, reserves can fall quickly. Bringing all these factors together, OMFIF’s emerging markets reserves index highlights Malaysia, Turkey and Mexico as particularly vulnerable.
China may have faded from the headlines since the 2015 stock market panic. However, in the background the balancing act between addressing the debt overhang and sustaining strong economic and employment growth has remained a big challenge for policy-makers. A potential hard landing is an important downside risk for other emerging markets with strong trade links to China. Elsewhere, while a stronger commodities market will provide a boost to some economies such as Mexico, Venezuela, Russia, Brazil, and the Gulf, their economies remain vulnerable to high inflation and a resulting economic slowdown.
Whether the dismal scenario of an emerging market crisis materialises depends critically on the path of US rates over 2017, as well as on the scale of divergence of Donald Trump’s policies once in office compared with his campaign pledges. Unlike yesterday’s rate hike, neither of these can be predicted with certainty. Scenarios range from a quick move to fiscal stimulus coupled with rising inflation and several rate hikes, to a cautious Fed in the face of an economic slowdown as Trump faces resistance from Congress and loses the confidence of markets. Emerging economies should prepare for either. Reserves data suggest on average they are better prepared to weather sudden capital stops compared with previously recorded crises, but there is huge variability with exposure to the dollar and US trade playing a key role.
Danae Kyriakopoulou is Head of Research at OMFIF.
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