By Mohamed A. El-Erian
U.S. officials have taken to the airwaves over the last few days to absolve the Federal Reserve of blame for the recent turmoil in emerging markets, a response to some of the debate that arose from the Federal Reserve Bank of Kansas City’s annual meeting last week in Jackson Hole, Wyoming.
The most common argument — that the Fed’s dual mandate of price stability and maximum employment is limited by law to domestic objectives — is correct. But that line of reasoning is too narrow given the feedback loops between emerging markets, corporate earnings and the U.S. economy.
There are two distinct narratives about the links between Fed policies and financial volatility in emerging economies.
The first has been put forward most forcefully by officials in emerging-market countries.
They argue that the Fed’s prolonged reliance on an experimental mix of unconventional monetary measures — namely, zero interest rates, aggressive forward guidance and large asset purchases known as quantitative easing — pushed investment capital out of the U.S. and toward emerging economies. The scale and scope of these funds triggered two types of legitimate concerns.
On the way in, the surge in capital led to appreciating currencies, reduced export competitiveness and fueled pockets of financial excesses. The reversal began in earnest in May amid market perceptions that the Fed planned to taper its market interventions. On the way out, the flows have caused sharp exchange-rate depreciations, spikes in local interest rates, and fears of inflation and diminished growth.
No wonder emerging economies in general, and Brazil in particular, have been so vocal about the negative consequences of the Fed’s unconventional policies. Such complaints have been amplified by the Bank of Japan’s policy shift and the subsequent depreciation of the Japanese currency, which makes the country’s exports cheaper relative to other countries.
A second narrative comes from U.S. officials. Based on the correct observation that the Fed is mandated by Congress to pursue domestic objectives, these officials have been quite dismissive of the concerns of emerging economies, using a mixture of arguments: from urging them to adapt their own policies to minimize the adverse effects of quantitative easing to suggesting that emerging economies would be better off because quantitative easing would revive growth in advanced countries, and thus the rest of the world.
Yet U.S. officials should be careful. With domestic growth engines again falling short of expectations, the last thing the U.S. needs is a weakened corporate outlook due to faltering growth in emerging economies.
So far, the negative effects have been confined to a few companies in specific markets. These tend to be companies that rely heavily on sales to emerging economies but don’t produce there. Their unhedged revenues are falling due to exchange-rate movements, while demand prospects are dimming.
The effects will spread if the financial upheaval persists. The impact would be especially severe in countries with large current-account and budget deficits, limited growth prospects, and small international currency reserves.
In that case, it will be just a matter of time before consumption begins to fall. Higher domestic market interest rates magnify this, discouraging new investment in plants and equipment.
Having already depleted some of their international reserves to counter exchange-rate pressures, some countries would now be more inclined to raise interest rates, adding to the growth headwinds. In the meantime, the use of reserves is already being reflected in lower incremental demand for U.S. financial assets.
Agustin Carstens, Mexico’s central bank governor, is right: Central banks in rich countries cannot conduct policy in a vacuum. The Fed, in particular, can’t — and shouldn’t — dismiss the impact of its policies on emerging economies. Potential feedback loops are just too important to ignore; they pay little attention to boundaries of the Fed’s official mandate, no matter the legal arguments.
Mohamed A. El-Erian is the chief executive officer and chief investment officer of Pacific Asset Management Co.
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