The FOMC And Emerging Markets

by: Desmond Lachman

As the Federal Reserve's Open Market Committee (FOMC) convenes to deliberate its next steps in exiting from its quantitative easing policy, one hopes that it is paying close attention to the emerging markets' economic outlook. For there now would appear to be increasing risks that emerging markets could pose severe challenges to the global economic recovery and could unsettle international financial markets. Those risks would be exacerbated by too hasty a Fed exit from quantitative easing, which would only further cloud the external prospects for US exports and further unsettle global financial markets.

The most immediate risk to the global economic outlook comes from a number of emerging market economies experiencing severe foreign exchange market pressure associated with the start of Fed tapering. The currencies of major emerging market economies like Brazil, India, Russia, South Africa and Turkey are now all swooning as the large capital inflows to these countries over the past few years are now reversing back to the United States.

Fueling these capital reversals is the market's growing concern with the external imbalances that these countries allowed to develop during the good years of ample global liquidity. Not helping matters is the prospect that many of these countries, including Brazil, India, South Africa and Turkey, face contentious elections this year that could further shake investor confidence.

Those emerging market countries facing currency pressure must be expected to tighten their financial policies in an effort to stabilize their currencies and to contain inflationary pressures. Such a shift in policy must be expected to significantly slow down their economies. This will be occurring at the same time that Chinese policymakers are trying to deflate a credit market bubble in their country that poses the real risk of a faster slowing in Chinese economic growth in the year ahead than the markets are presently anticipating.

The reason that the Fed should be paying close attention to emerging market developments is that these countries now account for around half of the world's gross domestic product. As such, what happens in the emerging markets could have an important bearing on US external prospects. This is all more so the case given the very real risk that a further deterioration in emerging market prospects could focus the market's attention on the very poor public debt dynamics and the very unsettled political outlook in the European economic periphery.

In setting its policy course, the FOMC should be mindful of not repeating its past mistakes of too abrupt a tightening in policy. This would appear to be particularly the case considering the increased inter-connectedness of global financial markets. In that context, the FOMC might want to reflect on the role that the Fed played through overly tightening US monetary policy in precipitating earlier emerging market crises that had global systemic consequences, like the 1994 Mexican peso crisis and the 1997 Asian crisis.

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