Why Fed ac­tion mat­ters more to devel­op­ing mar­kets than their own cen­tral banks

Daily Sabah (Turkey) - - Money - Taha Meli Ar­vas

Ev­ery­day reg­u­lar peo­ple around the world wake up, go to work, come home and go to sleep. They are touched by gov­ern­ments on a daily ba­sis for many things. Gov­ern­ments build roads and bridges, main­tain mass trans­porta­tion, tax goods and pro­vide other ser­vices like health care.

Gov­ern­ments can seem like the most im­por­tant in­flu­ence on a per­son’s daily life, but what if they are not? What if there are more im­por­tant ac­tors in a per­son’s day-to-day life that they are un­aware of? What if other gov­ern­ments in­flu­ence their lives just as much as their own, if not more? In a newly re­leased pa­per by Mat­teo Ia­coviello and Gas­ton Navarro ti­tled “For­eign Ef­fects of Higher U.S. In­ter­est Rates,” the ev­i­dence is clear that the U.S. Fed­eral Re­serve plays a ma­jor role in the lives of prac­ti­cally ev­ery­one world­wide.

The au­thors be­gin the re­port by men­tion­ing pre­vi­ous lit­er­a­ture which looked at spe­cific time pe­ri­ods for only a few coun­tries. They say that they “rely on a com­pre­hen­sive dataset con­tain­ing ob­ser- va­tions on quar­terly GDP and time-vary­ing coun­try char­ac­ter­is­tics for 50 for­eign economies for over 50 years.” The pa­per presents three im­por­tant re­sults. The first and most fun­da­men­tal re­sult of the pa­per is that the “for­eign spillovers of higher U.S. in­ter­est rates are large.”

In fact the ef­fects of a Fed­eral Funds rate hike by the FOMC (Fed­eral Open Mar­ket Com­mit­tee) of the Fed are on average as large over­seas as they are within the United States. Specif­i­cally, a rate hike of one per­cent equals about a cut in GDP of be­tween 0.5 and 0.8 per­cent in the three years af­ter the hike. U.S. GDP is cut by about 0.7 per­cent in the fol­low­ing two years.

The sec­ond re­sult of the pa­per, “In ad­vanced economies, higher U.S. in­ter­est rates are trans­mit­ted through stan­dard ex­change rate and trade chan­nels,” il­lus­trates the im­me­di­ate and di­rect im­pact of a rate hike on the ex­change rates of for­eign coun­tries. The more closely the two cur­ren­cies are cor­re­lated or the larger the trade vol­ume be­tween the two coun­tries, the re­sponse to the hike in ad­vanced economies is that much greater.

Fi­nally and most im­por­tantly for coun­tries like Turkey, emerg­ing mar­kets are not ef­fected in the way pre­vi­ously the­o­rized. While a rate hike would re­sult in an ap­pre­ci­a­tion of the U.S. dollar thus mak­ing Amer­i­can goods more ex­pen­sive and for­eign goods more com­pet­i­tive, this event “ex­plains lit­tle of the dif­fer­en­tial GDP re­sponses within economies” ac­cord­ing to the au­thors. The dif­fer­en­tial GDP re­sponses are in­stead ex­plained through a coun­try’s “fi­nan­cial fragility.” The au­thors then con­struct a “vul­ner­a­bil­ity in­dex” made up of “cur­rent ac­count, for­eign re­serves, in­fla­tion and external debt.”

The pa­per con­cludes with dis­cus­sion of the data and method­ol­ogy. The most im­por­tant take away is that “trade and ex­change rate ex­po­sure to the United States do not seem to mat­ter.” Es­sen­tially, coun­tries that are less frag­ile are also less vul­ner­a­ble to the ef­fects of a rate hike by the Fed­eral Re­serve. So while trade with the United States and re­la­tion­ship with the dollar may seem im­por­tant the fi­nan­cial health of a coun­try seems to be much more im­por­tant in weath­er­ing fi­nan­cial storms brought on by tight­en­ing of mon­e­tary pol­icy.

Turkey seems most vul­ner­a­ble to ex­oge­nous in­ter­est rate hikes through the “in­fla­tion” in­dex and how GDP re­sponds in emerg­ing mar­ket coun­tries with high in­fla­tion. By con­trast trade with the United States, for­eign re­serves, and even cur- rent ac­count deficits don’t mat­ter nearly as much as in­fla­tion and external debt com­po­nents.

So how should Turkey and other emerg­ing mar­kets best im­mu­nize them­selves from in­ter­est rate hikes that the Fed­eral Re­serve may im­ple­ment? The au­thors note that those best able to do so are coun­tries “that suc­ceed in keep­ing their fi­nan­cial house in or­der.” Ob­vi­ously the fi­nal sen­tence in the pa­per is eas­ier said than done.

Democ­ra­cies aren’t run by econ­o­mists with long-term ob­jec­tives but rather by peo­ple who are look­ing to bet­ter their lives in the short run. Keynes’ fa­mous quote on the topic, “In the long run, we are all dead!” sum­ma­rizes the is­sue per­fectly. Con­vinc­ing pop­u­la­tions to take nec­es­sary medicines for long-term fi­nan­cial health will not al­ways be easy and will never be pop­u­lar.

Per­haps the great­est take­away from this pa­per for Amer­i­can pol­i­cy­mak­ers is the im­pli­ca­tions of their actions on global fi­nan­cial health. In this era of glob­al­iza­tion a de­crease in de­mand over­seas very much im­pacts the U.S. econ­omy and there­fore U.S. pol­i­cy­mak­ers need to tread lightly be­fore ex­e­cut­ing data-in­de­pen­dent ide­o­log­i­cal tight­en­ing ex­per­i­ments like the one we cur­rently find our­selves in.

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