When the Federal Reserve sneezes, the rest of the world really does catch a cold.
U.S. monetary-policy tightening significantly raises the chances of a banking crisis in a country that has direct U.S. exposure, particularly if it’s an emerging economy, according to new research from economists at the Fed Board in Washington. The threat fades if a country is more globally integrated, the study found.
“A 1% tightening in U.S. monetary policy increases the default probability by about 1% to 7% for a given level of exposure to the U.S.,” authors Bora Durdu, Alex Martin and Ilknur Zer write in a Fed staff working paper posted on the bank’s website on Wednesday.
That will sound about right to the rest of the world, which was rocked by the taper tantrum in 2013 when the Fed unexpectedly discussed plans to begin slowing its emergency-era bond purchases. The prospect of less Fed stimulus triggered a sell off in riskier assets, including emerging-market bonds.
Some investors may also have memories of the international debt crisis following Fed tightening in the early 1980s under then-Chairman Paul Volcker, and the Mexican peso crisis that was preceded by Alan Greenspan’s rate hikes in 1994.
The Fed itself is acutely aware of spillovers to the rest of the world from its policy actions, which can blow back on the U.S. economy by slowing global growth and hence demand for U.S. exports. But the central bank is also wary of straying from the domestic goals set by Congress to focus on price stability and full employment.
The study provides a way to spot vulnerabilities to future banking crises in other countries by looking at how exposed they are to the U.S. Nations that do a large percentage of their trade with America have a higher exposure, for example.
The authors examine data on 69 nations between 1870 and 2010 and identify 239 banking crises. Such events occur in advanced economies roughly every 37 years.
Italy has the highest annual crisis probability among developed countries, at 6.4%, with Brazil topping the list among emerging economies at 7.8%, based on data on past episodes.
“When U.S. monetary policy tightens, foreign countries could experience capital outflows, leading to an adjustment in external accounts and domestic vulnerabilities,” the authors wrote. “If this correction is sudden, and sizable, it might lead to a sudden stop. Indeed, the countries that have direct exposure to the U.S. appear to be more prone sudden stops.”
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