Just because the Fed is telling us it won’t cause the next US recession doesn’t mean the coast is clear. Fragility is building in our interconnected global system. And the very fact that the Fed alone is powering ahead with interest rate hikes should be a source of concern. Fed Chairman Jay Powell’s views on the Fed’s role as global central bank make that clear.
Powell: The Fed isn’t as powerful as you think
Here’s what Powell said last week:
Since the Fed is the central bank of the world’s largest economy and issuer of the world’s most widely used reserve currency, it is to be expected that the Fed’s policy actions will spill over to other economies…
But the influence of U.S. monetary policy on global financial conditions should not be overstated. The Federal Reserve is not the only central bank whose actions affect global financial markets. In fact, the United States is the recipient as well as the originator of monetary policy spillovers…
Much of the discussion of the spillovers of U.S. monetary policy focuses on their effects on financial conditions in emerging market economies (EMEs). Some observers have attributed the movements in international capital flowing to EMEs since the Global Financial Crisis primarily to monetary stimulus by the Fed and other advanced-economy central banks. The data do not seem to me to fit this narrative particularly well…
Translation: The Fed is just one of many central banks these days. What we do affects our domestic economy a lot more than it affects foreign economies.
Powell: Fed policy won’t change for emerging markets
Powell goes on to say the following:
Monetary stimulus by the Fed and other advanced-economy central banks played a relatively limited role in the surge of capital flows to EMEs in recent years. There is good reason to think that the normalization of monetary policies in advanced economies should continue to prove manageable for EMEs.
It also bears emphasizing that the EMEs themselves have made considerable progress in reducing vulnerabilities since the crisis-prone 1980s and 1990s. Many EMEs have substantially improved their fiscal and monetary policy frameworks while adopting more flexible exchange rates, a policy that recent research shows provides better insulation from external financial shocks.
That’s the intellectual case for staying the course and ignoring what happens in the emerging markets.
Expect turmoil
What Powell is saying is that the Fed can normalize and it won’t have an undue impact on the emerging markets. His view is that any turmoil we see now is not because of Fed policy, but commodity prices, growth differentials, and EM macro policies.
The key takeaway here, then, is not about whether Powell is right. It’s that to the degree we are seeing turmoil in EM, it is going to continue until a drastic change happens. We can’t expect the Fed to ride to the rescue. It won’t.
What’s more, as I wrote in the last post, Atlanta Fed President Bostic’s assurance that the Fed won’t overtighten shouldn’t give any comfort to EM. Bostic is talking about safeguarding the US domestic economy and not about spillovers abroad.
Two more rate hikes in 2018 are a given. And that’s not good news for the emerging markets.
EM is vulnerable
Powell does say “I do not dismiss the prospective risks emanating from global policy normalization. Some investors and institutions may not be well positioned for a rise in interest rates, even one that markets broadly anticipate.”
But to deal with that, Powell says:
We will communicate our policy strategy as clearly and transparently as possible to help align expectations and avoid market disruptions. And we will continue to help build resilience in the financial system and support global efforts to do the same.
He specifically does not say the Fed will change course.
Moreover, there are indications that Powell has overstated the reduction in vulnerabilities in emerging market economies.
Argentina doesn’t have a big enough buffer of reserves to safely run a 5% of GDP current account deficit.https://t.co/icpRHOUfcD
— Brad Setser (@Brad_Setser) May 16, 2018
My view: as the Fed raises rates, it will be surprised both by how fragile EMEs are and by the spillover impact Fed policy still has abroad.