The Federal Reserve is many things

The Fed issued a statement of 790 words to justify its decision to yet again “taper” its quantitative-easing program. Most of the text focused on the US labour market, US inflation projections and the Fed’s assurances that US monetary policy will stay lax enough to support US economic growth even as its asset purchases drop. Not one word hinted that there was another country on earth.[1]

The lack of acknowledgement of the rest of the world may have astonished some. Over the previous weeks the Fed triggered disarray on global stock and currency markets when it implemented its first US$10 billion drop in monthly asset purchases from US$85 billion. Emerging-market currencies were engulfed in the most turmoil as investors pulled money from developing-country securities to send it largely back to the US to take advantage of higher-yielding US Treasuries. People who view the Fed as the world’s de facto central bank may have been surprised that Fed policy-board members failed to take these consequences into account before deciding to trim their asset purchases again.

They shouldn’t have been. The Fed is not the world’s central bank. It is as parochial as any other central bank when it comes to making decisions. Its mandate from Congress rightly only covers achieving outcomes for the US economy; namely, stable prices, full employment and the largely overlooked goal of moderate long-term interest rates. The Fed is there to conduct US monetary policy, act as banker for the US government and other US and foreign official financial institutions, operate and oversee the payments system, supervise and maintain the stability of the financial system and conduct research, among other things. It’s not there to worry about economic conditions in other countries unless turmoil elsewhere threatens the US economy. This sanguine approach by the Fed to any havoc created by its tapering has profound implications for the world economy.

To be sure, Fed officials do care about some pricing on financial markets, as the Fed’s statement in January points out. They mostly watch yields on US fixed-income markets because they have such telling economic impact; and they care to some extent what happens to US stocks for the flow-on effect to consumer sentiment and purchasing power. The Fed’s tapering is not the sole cause of the recent turmoil anyway – China’s credit tightening is hindering the world’s second-biggest economy, Argentina would have hosted a currency crisis anyway as its inflation is already out of control and political unrest is gripping Thailand, Turkey and Ukraine. Policymakers in some countries including Australia are glad the Fed’s tapering is boosting the US dollar because they want lower currencies to help their exporters. The policymakers bleating loudest about the ending of quantitative easing are often those who protested loudest when it began, claiming the Fed was starting currency wars. Perhaps, the Fed’s statement could have had a few sops acknowledging the turmoil in emerging countries.

But those words would ring hollow anyway to citizens in those emerging markets battered by the Fed’s tapering. People in these countries can guess that Fed officials have calculated that tapering is yet to trigger global side effects that will touch the US economy. Damage on financial markets would need to be far greater. Few emerging countries are key US export markets. US banks are not exposed to any large extent to falling emerging-market debt. In fact, the emerging-market turmoil has lowered US bond yields, making it easier for the Fed to persist with tapering, rather than put more pressure on it to suspend its timetable to end its asset purchases before year end. That was the likely message in Bernanke’s decision to make no mention of the outside world when justifying January’s decision.

Expanding list

Many implications flow from the Fed’s reminder that it is not a global welfare agency. The most obvious is that the Fed will steadily prune its asset buying as long as the US economy can withstand reduced purchases. Many in the US want the Fed to shrink its balance sheet. They are concerned that the Fed’s decision to more than double its balance sheet since 2009 to buy assets is fanning bubbles (perhaps) and could reignite inflation (unlikely). The US economic recovery appears solid enough even if hidden employment is high, Congress needs to again raise the US debt limit and factory orders suffered their steepest drop for 33 years in January (due, most probably, to a cold snap and previous stockpiling). Thus emerging markets can expect a struggle to hold onto the capital flows that came their way when the Fed, having reduced the cash rate to almost zero, began buying assets five years ago to reduce long-term US interest rates to spur the US economy.

The emerging markets most vulnerable to the Fed’s actions are those confronting political uncertainty and those with weak economic fundamentals. What started out as the “fragile five” – Brazil, India, Indonesia, Turkey and South Africa – has already expanded to become the “fragile eight” – Argentina, Chile and Russia have been added – and the roll threatens to grow. (Some include Hungary among the fragile rather than Chile.) Political strife on Ankara, Bangkok and Kiev streets and upcoming local, general and/or presidential elections in India, Indonesia and Turkey have prompted investors to pull money from these places. On top of political uncertainty, these and the other wobbly countries are vilified for their large current-account deficits, declining forex reserves, sluggish economic growth, hefty fiscal deficits and inflation. The Bank of International Settlements warned that the “massive expansion” by banks and companies in developing countries to sell bonds leaves emerging markets more exposed to the whims of foreign investors than they were during the East Asia crisis in 1998.[2]

A big problem is how emerging countries are responding to the loss of capital and the resultant dive in their currencies. Countries such as Brazil, India, Indonesia, South Africa and Turkey are defending currencies by raising interest rates – some such as Argentina and Ukraine have imposed capital controls while Russia is blowing forex reserves. After years of overly lax monetary policies in these countries, central banks are acting prudently to some extent to prevent plunging currencies boosting inflation. But for most part they are wrecking short-term growth prospects, putting their banking systems under pressure and stand little chance of propping up currencies for too long anyway. So worried are policymakers about holding onto foreign capital that even emerging markets with current-account surpluses (such as Chile and Peru) are wary of cutting key rates to stimulate their slowing economies.

Fed nemesis

The emerging countries deemed fragile are being urged to abandon the populist macroeconomic policies of recent years (low rates, fiscal deficits, prioritising growth over fighting inflation and anti-free-trade policies) and undertake structural reforms to win back the confidence of foreigners. They have much to do to convince outsiders that they have the political will to fix government finances, control banking sectors, stimulate domestic competition, boost productivity and encourage direct foreign investment. Over the long term, these countries probably will address many of their shortcomings and rebuild faith in the still-sound, long-term case for emerging markets. But the short term is another matter. A sudden slowdown is taking place in many emerging markets. That it is happening in so many large emerging markets at once is akin to a global disinflationary shock – as the prices of commodities and manufactured goods decline – particularly so if China pushes down the yuan to hold onto export-market share as it battles the aftermath of a credit boom.

Tamer inflation will be one beneficial outcome from the crisis for the fragile emerging countries infested with this curse. But a wave of disinflationary pressure from the emerging world is a big threat to the rest of the world. Japan will face a tougher struggle to escape its deflation. The heavily indebted eurozone could be pushed into the Japan-like daze, given how close it is to this stupor anyway. Prices in the 18-member eurozone only rose 0.7% in the 12 months to January, mainly because the fixed nature of the euro for its users is forcing countries with current-account deficits to deflate their economies to become competitive again. Deflation on an annual basis has already taken hold in the troubled countries of Greece, Cyprus and new euro-user Latvia and inflation is close to zero in Ireland, Slovakia, Spain and Portugal. Even if inflation stays just above zero in the eurozone, inflationary expectations have probably fallen low enough to drive up the real burden of debt to problematic levels.

Deflation is the menace the Fed probably worries about the most when judging whether a sick world could infect the US economy. Consumer prices only rose 1.5% in the US in 2013, so the margin for preventing the US economy entering into a long-term coma that worsens debt ratios is not huge. As much as the US might sometimes pretend it’s a closed economy, the outside world is still there. It could even crack a mention in Fed statements later this year if  new Chair Janet Yellen needs to explain why the US central bank has suspended tapering – for the sake of the US economy, of course.

Financial information comes from Bloomberg unless stated otherwise. Eurozone data comes from eurostat.

by Michael Collins, Investment Commentator at Fidelity

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