How will emerging economies react to Fed tightening?

The U.S. Federal Reserve has been letting the world know for a while that it will soon embark in an interest rate tightening cycle, after years of leaving policy rates near zero to stimulate growth after a devastating financial crisis and recession.

But despite the careful buildup, there is a possibility that the Fed tightening cycle could at some point rattle financial markets, with potentially difficult consequences for the most vulnerable emerging and frontier markets, a Policy Research Note from the World Bank’s Development Prospects Group concludes.

Not only have the approximate timing of the Fed tightening cycle and plans for it unfold gradually been well advertised, but the conditions behind it are plain as well. The U.S. labor market appears on solid footing and economic growth has been gaining momentum.

So the first rate hike – known to Fed watchers as “liftoff” – and subsequent increases likely to follow throughout the process should come as no surprise to financial markets, policymakers, and the multitudes of academics, journalists and think tank experts around the world who parse the Fed’s every word.

The research note, “The Coming U.S. Interest Rate Tightening Cycle: Smooth Sailing or Stormy Waters?” stipulates that the most likely outcome of the Fed tightening cycle is benign. It is happening because U.S. policymakers deem the world’s largest economy to be healthy, which has positive implications for emerging and frontier markets.

But memories of market turbulence in 2013 are fresh. In the spring of that year, Ben Bernanke, then Fed chairman, said in a speech the central bank could soon begin to taper off its pace of quantitative easing. Markets were caught off guard. Yields on long-term U.S. Treasury bills jumped a full percentage point, emerging market and frontier economy currencies depreciated sharply, and portfolio flows to the developing world shrank. The episode has become known as the “taper tantrum.”

What could happen if, at some point during the Fed’s tightening cycle, financial markets have the same reaction as they did during the 2013 taper tantrum? The fear is that capital flows to emerging and frontier markets could suddenly slow to a trickle, hurting growth and development. The research note says a similar spike in yields today could cause capital flows to emerging and frontier markets to contract by up to 2.2 percentage points of their combined GDP – a serious challenge for vulnerable economies.

Risks of financial market pressures during the Fed tightening cycle are heightened now by several factors, the report argues. For one, the term premium—the difference between long-term and short-term interest rates—is well below historical averages and could correct abruptly. Also, market expectations of future interest rates are below those of Fed policymakers—and the gap could close suddenly. These factor, in combination with fragile market liquidity, could generate substantial market volatility.

Add to that soft global growth, subdued world trade, and low prices for commodities that many emerging and frontier economies depend on for income—as well as underlying weaknesses, increasing vulnerabilities, and policy uncertainties in a number of such economies—and you have the potential for significant turmoil.

All of these point to reasons why policymakers in emerging and frontier markets would do well to make sure there are reducing vulnerabilities and putting in place policies to boost growth. They may hope for the best, but they need to prepare for the worst.

This article was originally published on The World Bank’s Let’s Talk Development Blog. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Carlos Arteta is a Lead Economist in the Development Prospects Group of the World Bank.

Image: A detail from the front of the United States Federal Reserve Board building is shown in Washington. REUTERS/Gary Cameron.