Not So ‘Decoupled’ After All, Emerging Markets Watch the Fed
For a while central banks in Indonesia, Brazil and elsewhere seemed free to do their own thing. No longer.
Chairman Jerome Powell wants us to know that the Federal Reserve isn’t to blame for the sell-off in emerging markets. Perhaps it isn’t. But the Fed has been spotted in the vicinity.
The connection between emerging markets and the U.S. economy never “decoupled,” as is popularly observed. The relationship merely evolved. From extreme examples like Argentina, where interest rates soared to 40 percent, to more benign scenarios like those in Brazil and Indonesia, which may merely cease cutting or start to claw back some cuts, investors are scrambling to adjust to a changed environment.
That’s an environment where the Fed is likely to raise U.S. rates a little more than projected — not dramatically — and American inflation stays around target while unemployment continues to grind lower toward, say, 3.5 percent. In the euro zone, the end of quantitative easing is in sight this year even if an actual rate increase is still a ways off. While this is all happening gradually, it's cumulatively a big shift. (Throw in a jump in U.S. 10-year Treasury yields to 3 percent, a huge expansion in fiscal policy and trade tensions, and it’s a potent cocktail.)
The prime culprit for tumbling emerging-market currencies and stocks is overwhelmingly identified as rising U.S. interest rates. Implicit in this view is that the Fed did a runner and emerging markets could party on without adult supervision. That mainly meant taking advantage of quiescent domestic inflation by cutting rates to juice growth. The environment in the U.S. was so benign for so long, they could get away with this.
But the Fed didn’t vacate the premises. It was just so transparent and so glacial in its moves and interest rates in America were still so low that developing world central banks could do their own thing without fear of being punished. That was a huge historical shift. In the past, emerging markets mostly had to raise rates along with the Fed to prevent the gap between their rates and those in America widening too much too soon. If they did, their currencies would slide, or so the narrative went.
Now some of those emerging-market officials probably wish they could take back some of those cuts they made while “doing their own thing.” Brazil is under pressure from investors to cut no more, and Indonesia will probably have to raise, perhaps as soon as this month. It turns out they were on the Fed’s leash all along. For a while they had some slack, and now it’s getting shorter.
Powell addressed the issue during a May 8 speech in Zurich. Don’t finger me for any roiling of emerging market economies, Powell said. The Fed’s influence is overstated. “There is good reason to think that the normalization of monetary policy in advanced economies should continue to prove manageable for EMEs,” Powell told a conference sponsored by the International Monetary Fund and the Swiss central bank.
On the whole that’s probably true. There’s a big difference, however, between “manageable” and handling something really well.
Now the game for emerging markets is to look over their shoulders at big brother — which for now still means the Fed. At some point, China will exert more influence than the U.S. on interest rates. We aren’t there yet.
Emerging markets still aren’t masters of their own destiny. It may have just superficially appeared that way for a few blissful years. So much for “decoupling” and the retreat of the West.
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