The first thing we should be asking is why now in particular, since conditions have not really changed much in the past few months. For example, back in September, there were large uncertainties in the global economy. China’s economic slowdown was causing alarm. Volatility in international capital markets was high. The appreciation of the US dollar was hurting US exports, which could (yet) mean slower US economic growth. That was not the time for the US Federal Reserve to up interest rates. But now it is – and here’s why.
The Fed’s decision might be taken as an acknowledgment that the persistence of low interest rates since the global financial crisis has increased risk-taking by investors and could cause instability in the financial system. That, in addition to declining unemployment rates, calls for a less expansionary monetary policy. At the same time, this was a window of opportunity to respond to growing expectations that an increase was coming. In a way, by clarifying that future interest rate hikes will be gradual, the Fed has also bought more time to see how the global economy responds before making its next move. It’s a signal that the US economy is strong.
What does it mean for emerging economies?
Increased cost of financing. Where emerging markets have been able to compete with the US for investors, they have had to compensate for their higher-risk status with higher rewards, or yields. A higher US interest rate only hurts their case by making “safer” US investments more appealing.
US dollar appreciation. Funds migrating away from risky countries toward the US will result in further increased appreciation of the US dollar. Since many corporations from emerging economies actively issued dollar-denominated debt after the global financial crisis, important currency mismatches between their assets (denominated in local currency) and liabilities (debt denominated in US dollars) might ensue, risking corporations’ capacity to service external debts. As experience has shown, private sector liabilities can often become public sector liabilities. Debt problems in a number of emerging economies is not out of the cards.
Increased differentiation between countries. Emerging markets will suffer unique consequences, but not all emerging economies will be hit as hard. Their resilience will be determined by the quality and reliability of domestic fiscal conditions and policies. For instance, Brazil’s large fiscal deficits and high inflation make it a poster-child for potential economic crisis. On the other hand, it’s hard to imagine a massive pull out from the Philippines because its financial house is in order. Basically, the market has seen this coming and identified some as problem economies—just this morning, Fitch Rating joined S&P in downgrading Brazil’s credit rating to junk status ahead of the hike. Not a coincidence.
What should they do next?
The answer to this depends on where you fall in the debate about what caused the US economic slowdown, whether it is the result of a process of deleveraging by banks, firms and households—and, therefore, lower consumption and investment following the US financial crisis—or a long-term productivity problem. If you see this as “secular stagnation” as Larry Summers has described, increasing rates will only make the US growth problem worse. I belong to the former camp. The US growth problem was one of debt-overhang that is largely resolved by now. If the Fed observes the response I have described above, then after the short-term volatility dissipates, it should proceed with gradual rate increases when the timing is right.