Emerging markets got slammed hard during the Taper Tantrum of 2013. But that doesn’t mean they will get slammed again when the Federal Reserve finally begins hiking rates, says, Alberto G. Musalem. In a speech, the executive vice president at the Federal Reserve Bank says emerging markets often prosper when the central bank enters a tightening cycle — but only if they aren’t taken by surprise.
Here are excerpts from Musalem’s speech (emphasis added):
Prospects of U.S. monetary policy normalization have raised concerns about international spillovers particularly for emerging market economies (EME). These concerns are understandable.
Looking back at previous periods of Fed tightening, average EME economic performance has actually been strong. For instance, industrial production growth has averaged between 7½ to 10 percent in the 12 months following individual Fed tightening cycles, while export volumes have risen 10 to 15 percent. These growth rates are comfortably above long-term averages. A likely explanation for this favorable record is that Fed tightening has recently occurred during periods of strong U.S. economic performance. The financial market performance of EMEs has been more varied, however. For instance, average financial market performance was strong in the tightening cycle that began in 2004, but very weak in the 1994 tightening cycle, and more mixed in the 1999 cycle. Of course, average performance hides considerable diversity across countries. In the 1994 tightening cycle, for example, the economic and financial performance of emerging Asia was strong while Mexico slumped and then fell into a crisis, with contagion to Latin America more broadly.
Concerns about EME economic and financial performance during Fed normalization also stem from the 2013 Taper Tantrum, when EMEs experienced sizeable weakening of their currencies, local currency and foreign currency bonds, and equity markets. Other factors also played an important role ahead of the Taper Tantrum, including record capital inflows into emerging markets, stretched asset valuations, and weaknesses in some countries’ domestic fundamentals. Market stress was most severe for countries reliant on external financing and, in these countries, led to slower growth.
The impact of eventual Fed monetary policy normalization on EMEs will likely depend mostly on the underlying domestic economic fundamentals of individual countries and onthe robustness of Fed communication.
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What accounts for the difference in EME performance across tightening cycles? Research suggests that anticipated Fed tightening moves have historically been followed by a minor pullback in private capital inflows, while unanticipated tightening moves have typically been followed by a pullback in private capital flows some four times as large. Research also suggests that the economic and financial performance of EMEs tends to be favorable when U.S. long-term yields rise because U.S. growth prospects are higher, as opposed to when U.S. yields rise because there is a monetary surprise not associated with higher U.S. growth prospects. This highlights the importance of transparency and clear messaging by the Fed about how it is evaluating the evolving economic landscape, to reduce the risk that policy adjustments might be associated with undue market volatility.
For the full speech, click here
Photo by Michael Daddino via Flickr.