Emerging economies must prepare for a US interest rate hike

Source: Economic Daily

At present, the pace of the Fed's tightening of monetary policy is accelerating, which may bring turmoil to global capital markets. Emerging economies need to plan early to deal with possible risk shocks.

Fed Chairman Jerome Powell was the first to specify the "rhythm" and "path" for tightening monetary policy when he attended the nomination hearing of the US Senate Banking Committee on January 11: it will end its asset purchases in March this year, followed by interest rate hikes within the year, and may begin to shrink its balance sheet later this year. Only 2 months ago, Powell repeatedly stressed that the Fed's reduction in asset purchases does not mean that interest rates are about to be raised, trying to distinguish between the two to appease the market. The Fed's sharp turn meant that it was tightening monetary policy faster than the market had initially expected.

Compared to the last time the Fed tightened monetary policy, the U.S. economy is in a completely different shape and has a larger balance sheet. Therefore, the Fed will shrink its balance sheet earlier and faster this time, and the interval between ending asset purchases and starting to shrink its balance sheet may be shorter. Most Fed officials expect three rate hikes this year. Institutions such as Goldman Sachs even expect the Fed to raise interest rates four times this year.

It is worth noting that just a day before Powell made this statement, the International Monetary Fund (IMF) warned emerging economies that emerging economies must prepare for the Fed to tighten monetary policy faster. Although the global economy is expected to continue to recover this year and next year, the downside risks to growth are exacerbated by repeated outbreaks. Given that this risk may coincide with a faster tightening of monetary policy by the Federal Reserve, emerging economies should be prepared for potential economic turmoil.

This reminder is very timely. Historical experience shows that if the Fed's monetary policy tightens and inflation tends to be moderate, and the tightening is carried out in an orderly and gradual manner, properly responding to the growing recovery process, its impact on emerging economies may be benign, and the currencies of emerging economies may still depreciate, but foreign demand will offset the impact of rising financing costs. However, if the Fed raises interest rates faster than expected, it could disrupt financial markets and tighten global financial conditions, which could be accompanied by a slowdown in U.S. demand and trade, and accelerate capital outflows and currency depreciation in emerging economies.

Currently, U.S. inflation remains high, and U.S. Department of Labor data shows that in December 2021, the U.S. Consumer Price Index (CPI) rose 7% year-on-year, the largest year-on-year increase in 40 years, exceeding 6% for three consecutive months. Moreover, the imbalance between supply and demand in the United States is still continuing, the problems of container port congestion and "labor shortage" have not been alleviated, and inflation expectations are gradually rising, which does not rule out the possibility of further accelerating the pace of tightening.

Emerging economies themselves are also facing high inflation and rising pressures on public debt. Average total government debt in emerging economies has risen by nearly 10 percentage points since 2019. By the end of 2021, emerging economies are expected to have 64% debt-to-GDP. While there are large differences between emerging economies, their economic recovery and labor markets are less robust than those of the United States.

In this case, the impact of the Fed's tightening of monetary policy on vulnerable countries may be even more severe. In recent months, public and private debt, as well as emerging economies with high foreign exchange risks and low current account balances, have seen their currencies fluctuate more relative to the dollar. Slower growth and increased vulnerabilities could create adverse feedback loops for these economies.

Some emerging economies have already begun to adjust monetary policy and are prepared to scale back fiscal support in response to rising inflationary pressures. For example, Brazil's central bank raised interest rates eight times in 2021, and the current benchmark rate is 9.25%; the Central Bank of Russia raised interest rates seven times in 2021, pushing the benchmark rate to 7.5%; and the South African central bank raised interest rates to 3.75% in November 2021, and is expected to raise rates by another 150 basis points before 2023. However, considering the possible risks and challenges, emerging economies must pay more attention to the rhythm of monetary policy adjustment in major economies, and improve their ability to cope with shocks by strengthening policy communication, raising interest rates, and adjusting fiscal structures in light of their own conditions. (Source of this article: Economic Daily Author: Gao Weidong)