(Revised) Should the Fed be responsible for the sell-off in emerging markets?

Not surprisingly, the Fed decided to scale back its bond purchase program by $10 billion a month on last Wednesday, bringing the monthly total down to $65 billion. It is also worth mentioning that the decision was unanimous, which was the first time there has not been a dissent at a policy meeting since June 2011.

Again, the Fed emphasized that its exit strategy would be data-dependent – if there is strong evidence of improvements in the overall economy, mainly signaled by unemployment rate (below 6.5%) and inflation target (around 2%), it could continuously taper the bond purchase in “further measured steps at further meetings”, said the Fed chief Ben Bernanke.

Therefore, the $10 billion cut seems reasonable, given that the U.S. economic fundamental is improving and the Fed has become more optimistic about the nation’s future. Nevertheless, the decision could be somewhat controversial if the current situation of emerging markets is taken into consideration.

In the past few weeks, there has been a significant sell-off of emerging-market assets, partly due to the expectation of the Fed’s tapering. The reason behind is fairly simple – the U.S. economy is on the right track and the liquidity created by QE is decreasing, so investors tend to re-allocate their assets from those risky markets to the U.S. on its stronger risk-return payoff. As a result, the Fed statement surprised some people because of the complete ignorance of emerging markets.

From my perspective, the ignorance was grounded by two key reasons.

First, the turbulence in emerging markets was also caused by economic slowdown and uncertainties in developing nations. The Chinese manufacturing shown by its below-forecast PMI (Purchasing Manager’s Index) triggered pessimistic outlook on domestic consumption of the world’s second-largest economy and threatened the growth in other energy-dependent nations such as Brazil and Argentina. The weakening euro was hit by a return to record-low inflation in the euro zone and in particular, the Turkish lira was under attack due to political scandal and a wide trade deficit in that country.

Second, more importantly, although the Fed’s QE has a worldwide impact and even led to market distortion in some nations, the American central bank is only committed to assessing the health of the U.S. economy and taking actions accordingly. That is to say, the tapering decision should be based on the strength of economic recovery in the U.S. rather than in the rest of the world. Richard Fisher, President of the Federal Reserve Bank of Dallas claimed that the Fed should end its bond-buying stimulus effort as quickly as possible, and added in this time of unsettled global markets, the Fed has to pursue policies that benefit the American economy.

Therefore, the Fed is primarily responsible for the U.S. economy because of its role as the American central bank. Nevertheless, given the fact that it is the most influential central bank in the world and the QE has been injecting massive financial liquidity to many other countries, international cooperation on monetary policy is still something to expect.

Specifically, on one hand, the International Monetary Fund, an organization aimed at fostering global growth and economic stability, should further take advantage of its research and statistics to keep track of the economic health of its member countries and advise them, especially those developing nations, on economic management and capital flow control. On the other hand, the U.S. should take more responsibilities by making its tapering process more understandable and adjusting the pace in line with market expectations. As the Indian central bank governor Rajan said: “Industrial countries have to play a part in restoring that, and they cannot at this point wash their hands off and say we will do what we need to, and you do the adjustment you need to.”

2 thoughts on “(Revised) Should the Fed be responsible for the sell-off in emerging markets?

  1. gkugler

    Turmoil in emerging markets has certainly been a central story recently. Although I agree the Fed’s decision might have contributed to the sell off in emerging markets, I think many of the countries that make up “emerging markets” have country specific problems. Rather than there being systematic risk threatening all emerging market economies, I think there is a strong case for idiosyncratic risk causing much of the trouble. Nonetheless, the weakness in emerging markets culminates in depreciation relative to the dollar (as the U.S. economy continues to strengthen).

  2. dslavin

    I would agree with gkugler. Although tapering did have an impact on the emerging market sell off, I think the internal problems in EMs is what scared investors away. I would also argue that the current capital inflow into safe havens like Japan and the U.S. will not last. I think that we will see some capital flow back into EMs after investors realize that U.S. and Japanese bonds are overvalued.

Comments are closed.