Fed rate hikes and their domino effects on emerging markets. Who catches a cold this time?

Fed rate hikes and their domino effects on emerging markets. Who catches a cold this time?

July 25, 2018

Maria Paola Priola, Lorenzo Prosperi, Giacomo Tizzanini, Charles Wan

The US monetary policy has global repercussions from which no economy, large or small, can be shielded

 

Nowadays, the US economy stays on a solid path, comfortably supported by an expansionary fiscal policy. Ten years after the subprime crisis, promising statistics of unemployment rates and expected wage growth alert the Federal Reserve to the possibility of speeding up the normalization process for the policy interest rate.

In the last Fed meeting, not only did Chairman Jerome Powell underline the economy’s strength despite a slowdown in GDP growth in the first quarter of the year, but he also removed the wording of forward guidance linked to the inflation target. Not surprisingly, the Fed projected two additional hikes in the Federal funds rate this year and at least three more in 2019.

The US monetary policy has global repercussions from which no economy, large or small, can be shielded. Looking at the past, global investors have usually reacted negatively to emerging markets in the context of Fed rate hikes. It is often said that “when the US sneezes, the world markets catch a cold”. Standard economic theory suggests that once the Fed proceeds with rate hikes, the US dollar tends to appreciate and the financial risk-return mix changes in all countries.

In this case, central banks might increase interest rates to contain financial outflows. Nevertheless, an increasing number of emerging countries pursues macroeconomic stability as a policy goal. To what extent will a restrictive monetary policy in the United States affect emerging economies this time around?

 
Fig. 1 Emerging countries distribution of government bond yields responses to 25bps US policy shocks(a) (per cent)
Fed rate hikes and their domino effects on emerging markets. Who catches a cold this time?
Source: Thomson Reuters, Prometeia calculations. (a) Emerging countries are Brazil, China, India, Nigeria, Russia, Saudi Arabia and Turkey.
 

Although there might be persistent volatility in the emerging markets in the short term, investors could weigh the risk of dramatic economic downturns rather differently than before thanks to the general improvement in fundamentals and to the Fed forward guidance. We may expect greater aftershocks in countries with huge imbalances.

To find out a response to the previous question, we deploy as analytical tool the international Data-Rich Environment Vector Autoregressive Model (iDREAM), [1] extended and applied to a panel of 18 countries (in the previous version it included 11 countries). [2] 

The iDREAM is a macroeconometric model for data-rich environments effective in capturing real and financial linkages on a global level, allowing us to model transmission mechanisms for impulse-response analysis across countries. To solve the “curse of dimensionality” problem typical of data-rich environments, we extract three latent factors – business cycle, monetary policy and inflation – from the around 40 to 50 macroeconomic time series available for each country. Moreover, we add three observable variables (the real effective exchange rate, 3-month and 10-year government bond interest rates). The US takes on oil price as an additional global variable. Each of the 18 countries is then modelled as a small open economy with endogenous domestic variables and weakly exogenous foreign variables country-weighted according to an adjacency matrix. 

Different from most of existing approaches, we do not derive the adjacency matrix from bilateral trade flows but rather estimate them as network connectedness defined by the share of forecast error variation in a variable due to shock arising in another variable. This feature gives the model the ability to adapt to continually changing financial and trade linkages between countries.

To evaluate the effects of a 25 basis point increase in the Federal funds rate we employ impulse-response analysis. We identify a monetary policy shock by means of sign restrictions, i.e. such a shock should increase the short-term interest rate and reduce the monetary policy factor for 6 months (implying that the Fed total assets continue to shrink) and have a negative impact on inflation in the US. Based on these assumptions, the model intuitively suggests that the long-term interest rate will also increase and the dollar will appreciate. As expected, economic activity in the US declines because of a contraction in lending to the real economy.

 
Fig. 2 Emerging countries distribution of business cycle and real effective exchange rate responses to 25bps US policy shocks (a)(b) (per cent)
Fed rate hikes and their domino effects on emerging markets. Who catches a cold this time?
Source: Thomson Reuters, Prometeia calculations. (a) Emerging countries are Brazil, China, India, Nigeria, Russia, Saudi Arabia and Turkey. (b) The effects on real effective exchange rate are the difference between domestic currency and US responses.
 
 

In our model, the responses of emerging countries to a Fed rate hike are both weaker in magnitude and more heterogeneous than those of developed ones, as the business cycles of emerging countries are overall less synchronized with that of the US. Divergences in the economic fundamentals of the different emerging economies would also imply heterogeneity in the intensity of responses to the shock and central bank response functions. Countries with a significant amount of debt denominated in foreign currencies and a huge deficit in the balance of payments are at greater risk of capital outflow. Their respective central banks would have to raise interest rates in response to Fed tightening in order to stem capital outflow, shore up domestic currencies and reduce inflation rates. 

Indeed our results show that emerging countries would experience a rise in interest rates and the inflation latent factor at least in the short term, with a slowdown in their business cycles after two quarters and domestic currency depreciation against US Dollar (Fig. 1-2). 

Conversely, our model suggests that China should keep interest rates roughly unchanged. This is in line with the fact that countries with relatively comfortable balances of payments and/or external debt structures (mainly composed of long-term liabilities) could better afford an expansionary monetary policy in order to support domestic demand, making up for the shortfall in global demand.

In conclusion, the normalization of US monetary policy should not have significant repercussions on global economy due to Fed forward guidance and to general improvement in fundamentals in emerging countries. Therefore, “when the US sneezes, someone might catch a cold." But penicillin is not needed.

 
 
[1] See De Meo E., Prosperi L., Tizzanini G. and Zicchino L., (2017), “Forecasting macro-financial variables in an International Data-Rich Environment Vector Autoregressive Model (iDREAM)”, Prometeia Working Papers.
[2] We consider the following countries: Australia, Brazil, Canada, China, France, Germany, India, Italy, Japan, Korea, Nigeria, Russia, Saudi Arabia, Spain, Switzerland, Turkey, United Kingdom, US.
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