As the Federal Reserve prepares to gradually wind down its stimulus program, some fear that the policy reversal could cause emerging economies to fall like dominoes.
But the question is: Should the Fed really care?
That’s the focus of much debate at a gathering of central bankers and economists in Jackson Hole, Wyo., Saturday.
While the Fed was trying to save the U.S. economy over the last four years by pushing interest rates down to historic lows and going on a bond-buying spree, the value of the U.S. dollar fell, prompting investors to seek higher returns in riskier markets.
Emerging economies like India, Brazil, Indonesia and countries in Eastern Europe all benefited from large influxes in U.S. dollar-based loans over those years.
Real estate prices rose in China, Korea and Thailand. Stock prices increased in China, Mexico and Russia, and credit became far more available to borrowers in Brazil, China, Korea and Turkey.
But now, as the Fed prepares to slow and then eventually end its stimulative policies, the U.S. dollar is already rising versus foreign currencies like the Brazilian real and the Indian rupee. Investors are pulling their money out of these countries, triggering fears of a panic.
“From the Fed’s perspective, communication about tapering is important not only to Americans but to foreign audiences as well,” said Glenn Hubbard, dean of the Columbia University Graduate School of Business and a former adviser to President George W. Bush. “A lot of the reaction in emerging markets has been about what the Fed means.”
Here’s how a crisis could play out: As emerging market currencies fall, the fear is that borrowers in these countries may not be able to pay back their dollar-denominated loans. Should they default en masse, their domestic banks could suffer or even fail.
Meanwhile, just because their own currencies are falling, doesn’t mean prices will be going down too. In countries that import food and oil from abroad — often priced in U.S. dollars — basic necessities will become more expensive to the average person.
It’s a recipe for geopolitical unrest, said Philippa Malmgren, president of Principals Asset Management and former economic adviser to President George W. Bush.
“Ironically, they get even more inflation now, and this is a profound issue,” she said. “People in emerging markets spend 40% to 70% of their income on food and energy alone. Where an American can grumble about their grocery bill going up, it’s marginal for most Americans, whereas for emerging markets, it’s life and death.”
Two papers presented in Jackson Hole urged central bankers to think of the international repercussions of their own domestic policies. Christine Lagarde, managing director of the International Monetary Fund, also delivered a speech calling for more international cooperation.
“No country is an island,” she said. “In today’s interconnected world, the spillovers from domestic policies … may well feed back to where they began. Looking at the wider effect is in your self-interest. It is in all of our interests.”
It’s not uncommon for smaller, emerging economies to coordinate monetary policy efforts. Countries from the Balkans, the Black Sea region and Central Asia for instance, created a central bankers club that meets to discuss how to align their policies.
Members include Turkey, Russia, the Czech Republic, Romania, Albania and Kazakhstan, to name a few.
“We have been coordinating policy before the crisis and during the crisis, and I think it is also time now to coordinate the policies after QE3,” said Ardian Fullani, governor of the Bank of Albania.
But for the United States, such coordination is not likely to be politically popular. Following the financial crisis, the Federal Reserve offered U.S. dollar swap lines to 14 countries. The cooperation between global central banks was “extremely successful overall” in easing tensions, but also drew ire from Congress and the broader public, noted Jean‐Pierre Landau, a former IMF and World Bank executive director, in a paper presented in Jackson Hole.
The discussion remains controversial because it conflicts directly with U.S. law. Congress has charged the Federal Reserve to form its policies around maximizing American jobs and keeping American prices stable. It says nothing about say, food prices or wages in India.
“The Fed is focused, entirely by law, on domestic things and there’s always been that clash,” said Alan Blinder, Princeton economist and former vice chairman of the Federal Reserve Board. “Anything that pushes us toward cross-border cooperation potentially clashes with the Federal Reserve Act.”
If there’s one key message that comes out of this year’s Jackson Hole symposium, it’s a new call to bring monetary policy up to date with the global economy. Indeed, the title of the confab is “Global Dimensions of Unconventional Monetary Policy.”
“Most central bankers believe that monetary policy is a purely domestic phenomenon and central bankers should only consider data from inside their own nations,” Malmgren said. “The question is: isn’t that a very quaint, old-fashioned notion in a highly globalized economy?”