World Bank Sees Muted Impact of Fed Liftoff on Emerging Markets

  • Fed tightening long anticipated and likely to be gradual
  • Financial volatility could trigger sharp capital outflows

The World Bank is expecting smooth sailing for emerging markets when the Federal Reserve begins raising interest rates for the first time since 2006.

But financial stress in global markets could spoil that forecast, triggering a rapid outflow of capital from the most vulnerable emerging economies, the Washington-based lender said in a report released Tuesday.

“There are multiple reasons to expect a smooth tightening cycle with only modest impact” on emerging and frontier economies, the bank said in a report by economists Carlos Arteta, M. Ayhan Kose, Franziska Ohnsorge and Marc Stocker. The start of a Fed tightening cycle has long been anticipated by financial markets and will most likely proceed “very gradually,” the report said.

The policy-setting Federal Open Market Committee meets Sept. 16-17 in Washington, and economists surveyed by Bloomberg News are evenly split on whether the panel will boost rates or delay a move. The target range for the federal funds rate has been held near zero since 2008.

The U.S. economy is robust, the spread between short- and long-term rates is likely to remain narrow and other major central banks are expected to continue to pursue exceptionally accommodative monetary policy, the World Bank economists also said.

‘Perfect Storm’

Still, the development bank warns of significant risks to its outlook, including uncertainty about the U.S. economy, the threat of an abrupt rise in long-term rates and fragile market liquidity.

“Financial market volatility during the tightening cycle could potentially combine with domestic fragilities into a perfect storm that could lead to a sharp reduction in capital flows to more vulnerable countries,” the report said.

Global policy makers are hoping to avoid a repeat of the so-called taper tantrum volatility that rocked emerging markets following indications by the Fed in 2013 that it planned to unwind its unprecedented bond-buying program.

Emerging markets should have monetary and fiscal policies that reduce vulnerabilities and strengthen policy credibility, as well as structural policy agendas to improve growth, the World Bank said.

“In the event that risks surrounding the upcoming tightening cycle materialize, exchange rate flexibility could buffer shocks in some countries but may need to be complemented by monetary policy measures and targeted interventions to support orderly market functioning,” the report said.

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