Fed Ignore Emerging Market Slump

The Federal Reserve followed expectations on Wednesday and voted unanimously to taper the current quantitative easing scheme, from $75 billion in January to $65 billion in February.  The Fed also extended their reverse repo experiment at the New York Fed and reiterated their commitment to short term interest rates being zero for the near future.  Although these policy actions were in line with expectation, some had been calling for the Fed to halt tapering to prevent the current crisis in foreign markets from getting any worse; however, the Fed ignored the current slump in foreign markets, highlighted by the weakening Turkish lira and South African rand.

A weakened currency hypothetically should help the net exports of these emerging markets by making the products cheaper to foreign buyers.  However, a weakening currency also make foreign debts larger in terms of domestic currency, and thus harder to pay.

Although the slump was certainly a complex mix of many factors, the planned reduction in quantitative easing is being blamed as a factor for the capital outflows from emerging markets.  The idea behind these claims is that as the government reduces the amount of stimulus through QE, investors will have higher available profits in the domestic markets, because the government won’t be driving up prices as steeply.  Thus, investors will take money out of the the riskier emerging markets to the more stable returns of the domestic market.

By continuing with the intended tapering policy, the Fed made a decision not to consider the potential adverse effects of their decision on foreign markets.  In fact, “Fed officials made no mention of these trends in the statement released Wednesday.”  In recent years, this has been the general strategy of the Fed, with chairman Ben Bernanke stating in 2011, “It’s really up to emerging markets to find appropriate tools to balance their own growth.”  Foreign central banks have taken this policy to heart in recent days, with the Turkish central bank raising it’s overnight lending rate over 400 basis points , and other small central banks enacting similar policies.  While their policies haven’t been very effective, these emerging markets clearly understand that the U.S. will not shape their policy to accommodate them.

I believe that the Bernanke and the Fed made the correct decision not to react to the fluctuations in the foreign markets in their policy decisions.  Some critics believe that many of these emerging markets had entered into a sort of bubble spurred on by high liquidity and large capital inflows, and thus a weakening in the markets were only natural.  Also, today, the emerging market currencies that were hit hardest last week have now recovered slightly, and are trending in a direction favorable to foreign governments.

Furthermore, I believe that the Fed should enact the monetary policy that is best for the U.S. economy.  Since the U.S. economy is not highly dependent on emerging markets, the Fed probably shouldn’t put too much thought into how their policy will affect emerging markets.  Also, if the U.S. economy improves overall, the foreign markets stand to benefit; what is good for the U.S. economy is good for the emerging markets.