The Fed’s Risk to Emerging Economies
The US Federal Reserve has finally, after almost a decade of steadfast inaction, set off down the path of interest-rate normalization. But other central banks' reluctance to follow the Fed’s lead implies a coming period of monetary-policy divergence, with uncertain consequences for the global economy.
MILAN – The US Federal Reserve has finally, after almost a decade of steadfast adherence to very low interest rates, hiked its federal funds rate – the rate from which all other interest rates in the economy take their cue – by 25 basis points. That brings the new rate up to a still-minimal 0.5%, and Fed Chair Janet Yellen has wisely promised that any future increases will be gradual. Given the state of the US economy – real growth of 2%, a tightening labor market, and little evidence of inflation rising toward the Fed’s 2% target – I view the rate rise as a reasonable and cautious first step toward normality (defined as a better balance between borrowers and lenders).
However, other central banks, particularly in economies where the output gap is larger than in the United States, will not be keen to follow the Fed’s lead. That implies a coming period of monetary-policy divergence, with uncertain consequences for the global economy.
On the face of it, a tiny change in the US rate should not trigger dramatic shifts in global capital flows. But, as US monetary policy follows the path of interest-rate normalization, there could well be knock-on effects, both economic and financial, especially in the form of currency volatility and destabilizing outflows from emerging economies.