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Abu Dhabi, UAETuesday 25 September 2018

Fed set to hike interest rates as emerging markets struggle

The US central bank is likely to raise rates at least twice by the end of the year

While the US economy has reported stellar results, with record low unemployment and the prospect of interest rate hikes by the Federal Reserve, emerging markets like Brazil are feeling the pressure. Qilai Shen/Bloomberg
While the US economy has reported stellar results, with record low unemployment and the prospect of interest rate hikes by the Federal Reserve, emerging markets like Brazil are feeling the pressure. Qilai Shen/Bloomberg

Emerging markets struggling with higher US interest rates are likely to get little sympathy from the Federal Reserve.

Emerging-market currencies have been hammered in a spreading selloff amid worries that their economies won’t cope with higher US borrowing costs. That’s prompted central bankers in India and Indonesia to urge Fed caution, while officials in Brazil are warning of challenging times.

There are few signs such concerns will steer the Fed away from its course for at least two and possibly three more rate hikes this year, including a move at its policy meeting next week.

Chairman Jerome Powell explicitly pushed back against criticism early last month in Zurich, saying the role of US monetary policy on foreign domestic financial conditions was “often exaggerated.” His colleague, Governor Lael Brainard, mentioned emerging markets in a May 31 speech, but spent far more time discussing the upside risks posed by fiscal stimulus.

“I don’t think they can change policy based on fear,” said Bricklin Dwyer, senior economist at BNP Paribas in New York. Emerging-market turmoil “is noise right now, justifiable noise. But does it shift the outlook for the US? The answer is, not yet.”

The US economy is powering ahead, adding over a million jobs in the first five months of 2018. Inflation is at the central bank’s 2 per cent target, and the Atlanta Fed’s gross domestic product tracking model suggests the economy grew a strong 4.5 per cent in the second quarter.

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Even if exports are tempered by foreign economic woes, trade fights, and a somewhat stronger dollar, some $1.5 trillion (Dh7.4tn) in fiscal stimulus and a $300 billion increase in federal spending are supporting domestic US demand with “a huge tailwind,” said Torsten Slok, chief international economist at Deutsche Bank in New York.

The Fed is tasked with achieving stable prices and full employment. At 3.8 per cent in May, unemployment is already well below estimates of full employment and recent forecasts show officials expect a modest overshoot of their 2 per cent inflation target.

Meanwhile, the Fed’s benchmark lending rate is still low enough to stimulate growth, according to some measures, leaving officials with little choice but to keep raising it to a level that is more neutral in its impact on supply and demand.

It has also gone out of its way to communicate the plan for gradual rate increases and a shrinking balance sheet to avoid repeating the 2013 taper tantrum, when then-Fed Chairman Ben Bernanke surprised investors by suggesting the central bank might slow bond purchases.

Delaying policy tightening could also carry costs for emerging markets if it led to higher inflation that forced the Fed to act more aggressively, said Nathan Sheets, chief economist for PGIM Fixed Income.

“The Fed’s got to move,” said Sheets, a former US Treasury undersecretary for international affairs. Officials are probably asking themselves, “over time, are we going to serve the global economy well by not responding to inflation?”

There have been occasions in the past when the Fed has paused in response to international developments. In 1998, for example, then-Chairman Alan Greenspan led the committee to cut rates three times to offset effects of spreading financial turmoil.

Greenspan warned during that period that “it is just not credible” that the U.S. remain “an oasis of prosperity.”

Greenspan ‘Wrong’

“He was wrong,” said Joe Gagnon, a senior fellow at the Peterson Institute for International Economics in Washington and a former Fed economist. “He eased 75 basis points and the economy, if anything, accelerated and the tech economy really took off.”

The bubble in technology stocks eventually burst at high cost to the US economy.

In 2016, Fed officials set aside plans to raise rates four times over the year in reaction to financial-market turmoil triggered by concern over slowing Chinese growth. They hiked just once, but could also point to US inflation that was running too low as a reason for their caution.

The Fed’s preferred gauge of price pressures averaged just 1.2 per cent that year, while it hit 2 per cent on a 12-month basis in both March and April 2018.

Fed officials do have an eye on Europe and emerging markets, “but at the end of the day, look at the employment report” in May, when the US economy added 223,000 jobs, said Deutsche Bank’s Slok. “If anything, we should be worried about overheating, not a recession.”

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