The Fed Ignores The Emerging Markets At Its Peril

by: Desmond Lachman

Image Credit: shutterstock

Image Credit: shutterstock

The Federal Reserve’s track record in anticipating major events that might seriously impact the US economy is hardly stellar. In 2007, for example, the Fed totally failed to anticipate the damage that sub-prime lending in the US housing industry would wreak on both the US and global financial systems. Today, at a time of increased turbulence in the emerging market economies, the Fed seems to be blithely oblivious to the risks that emerging market developments might pose to the US economic recovery. Indeed, in yesterday’s FOMC policy statement, there was not as much as a mention of the currency crisis gripping a number of the major emerging market countries.

What makes the Fed seeming unconcerned about the emerging market currency crisis all the more surprising is that there is every indication that this crisis will not be a fleeting phenomenon. As if to underline this point, on the very day of the FOMC’s meeting, we saw that significant interest rate hikes in India, South Africa, and Turkey failed to restore confidence in the emerging market currency markets. This would suggest that markets are looking for more than knee-jerk central bank rate hikes from policymakers. Rather, they are looking for more fundamental economic measures that might be aimed at correcting these countries’ underlying internal and external imbalances.

A reason for thinking that the emerging market currency crisis could continue in the months ahead is the unfortunate electoral cycle that these countries face. Important elections are scheduled in 2014 for Brazil, India, Indonesia, South Africa, and Turkey. In addition to heightening investor uncertainty, those elections are likely to preclude governments from taking unpopular measures to correct economic imbalances and to support the central banks’ efforts to stabilize their currencies.

It would seem that there are a number of reasons why the Fed ignores the emerging market currency crisis at its peril. First, emerging markets today account for over half of world GDP. As such, any marked slowing in these economies would have a direct bearing on the US and global economic outlook. Second, continued turbulence in the emerging markets must be expected to have a negative impact on global financial market and on risk appetite. By so doing, it would undermine one of the principal channels through which the Fed’s quantitative easing policies worked.

Third, it would seem to be only a matter of time before the emerging market turbulence draws the market’s attention again to the very poor public and private sector debt dynamics in the European economic periphery. This would seem to be particularly the case considering that European politics is already heating up ahead of the May 2014 European parliamentary elections. And, if Europe were indeed again to come into play, one would think that even the Fed would become alert to the international risks to the US economic recovery that are now staring it in the face.