MILAN – The U.S. Federal Reserve has finally, after almost a decade of steadfast adherence to very low interest rates, hiked its federal funds rate — the rate from which all other interest rates in the economy take their cue — by 25 basis points. That brings the new rate up to a still-minimal 0.5 percent, and Fed Chair Janet Yellen has wisely promised that any future increases will be gradual.
Given the state of the U.S. economy — real growth of 2 percent, a tightening labor market and little evidence of inflation rising toward the Fed’s 2 percent target — I view the rate rise as a reasonable and cautious first step toward normality (defined as a better balance between borrowers and lenders).
However, other central banks, particularly in economies where the output gap is larger than in the United States, will not be keen to follow the Fed’s lead. That implies a coming period of monetary-policy divergence, with uncertain consequences for the global economy.
On the face of it, a tiny change in the U.S. rate should not trigger dramatic shifts in global capital flows. But, as U.S. monetary policy follows the path of interest-rate normalization, there could well be knock-on effects, both economic and financial, especially in the form of currency volatility and destabilizing outflows from emerging economies.
The reason we should fear this possibility is that the world’s economic equilibrium is both fragile and unstable — and could wobble dangerously without determined and coordinated policy intervention. A Fed rate hike might not tip it over, but some other seemingly innocuous event could.
One doesn’t need a long memory to understand how even relatively modest policy shifts can trigger outsize market reactions. Consider, for example, the “taper tantrum” that roiled financial markets in the spring of 2013, after then-Fed Chair Ben Bernanke said only that policymakers were thinking of gradually ending quantitative easing.
But that announcement came as a surprise (as did the devaluation of China’s renminbi this past summer). Capital that had flooded into emerging markets seeking yields no longer available in developed economies abruptly reversed course. No investor wanted to be the last one out. A jittery global financial system, like the one we have now, does not tolerate unwelcome surprises well.
Unlike the taper tantrum and the devaluation of the renminbi, the Fed’s rate-hike announcement on Dec. 16 certainly was no surprise. So one might argue that if the Fed’s move does lead to volatility in international capital flows, the process must have already started. In fact, near-universal anticipation of a U.S. rate rise did not produce a spike in capital flows or asset prices.
Yet widespread concerns persist. The International Monetary Fund, for example, has argued that any rate hike by the Fed would need an “effective monetary policy communication strategy” — a polite way of saying that any monetary tightening in the U.S. and other advanced economies would be premature.
The reasoning is that emerging economies have become dangerously dependent on low interest rates and high commodity prices. Many emerging-market companies are in the highly vulnerable position of having borrowed heavily in foreign currencies. If capital flight occurs, the consequences will be dire: tightened credit, balance-of-payments difficulties, inflation, rising interest rates, fiscal stress and downgrades by the major credit-rating agencies — all of which implies more capital flight.
Europeans, too, have become dependent on low interest rates, with the European Central Bank as the key stabilizing force. Without the ECB’s commitment, in place since 2012, to prevent sovereign-debt yields from soaring, there would be a persistent risk to the eurozone — and, indeed, to the entire edifice of the European Union — of sovereign-debt defaults.
But at least Europe has benefited from falling commodity prices. By contrast, many emerging economies, highly dependent on commodity export earnings, have been stressed by the commodity-price reset, sluggish growth in developed economies and slower growth in China. Capital flight would materially add to their plight — in some cases disastrously so.
Since the 2008 financial crisis, the world has become accustomed to such linkages and spillovers. And yet policy responses to crises remain decentralized. There is no ECB for the emerging economies. They cannot be confident of appropriate reactions by their policymakers to rapid capital outflows, or of their capacity in terms of policy tools, reserves and balance sheets. And they cannot be fully certain of the speed and effectiveness of the international policy responses that might otherwise act as “circuit breakers.”
The reality is that emerging markets that benefited after the 2008 crisis from China’s economic growth, rising commodity prices and cheap foreign capital must now adjust to reversals in all of these factors. The necessary transitions for these markets will be complex, risky and not entirely within their control.
While the Fed’s rate hike, prudently accompanied by an emphasis on small and gradual steps, may not turn out to be a trigger, the concerns about the knock-on effects are legitimate. It would be unwise to assume that, with the initial hike now behind us, systemic risk has somehow disappeared.
In the long run, of course, emerging markets will benefit from interest-rate normalization, because they will no longer suffer the distortions and imbalances that lead to unsustainable growth patterns. But the hard part will be getting from here to there without an accident.
Michael Spence, a Nobel laureate in economics, is a professor of economics at New York University’s Stern School of Business and a senior fellow at the Hoover Institution. His latest book is “The Next Convergence — The Future of Economic Growth in a Multispeed World.” © Project Syndicate, 2015.
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