Credit Manager Magazine 2/2022

Emerging Economies Must Prepare for Fed Policy Tightening Policymakers may need to react by pulling multiple policy levers, depending on Fed actions and their own challenges at home. International Monetary Fund Blog For most of last year, investors priced in a temporary rise in inflation in the United States given the unsteady economic recovery and a slow unravelling of supply bottlenecks. Now sentiment has shifted. Prices are rising at the fastest pace in almost four decades and the tight labor market has started to feed into wage increases. The new Omicron variant has raised additional concerns of supply-side pressures on inflation. The Federal Reserve referred to inflation developments as a key factor in its decision last month to accelerate the tapering of asset purchases. These changes have made the outlook for emerging markets more uncertain. These countries also are confronting elevated in- flation and substantially higher public debt. Average gross government debt in emerging markets is up by almost 10 percentage points since 2019 reaching an estimated 64 percent of GDP by end 2021, with large variations across countries. But, in contrast to the Unit- ed States, their economic recovery and labor markets are less robust. While dollar bor- rowing costs remain low for many, concerns about domestic inflation and stable foreign funding led several emerging markets last year, including Brazil, Russia, and South Af- rica, to start raising interest rates. New risks to recovery We continue to expect robust US growth. Inflation will likely moderate later this year as supply disruptions ease and fiscal con- traction weighs on demand. The Fed’s policy guidance that it would raise borrowing costs more quickly did not cause a substantial market reassessment of the economic out- look. Should policy rates rise and inflation moderate as expected, history shows that the effects for emerging markets are likely benign if tightening is gradual, well telegraphed, and in response to a strengthening recovery. Emerging-market currencies may still depre- ciate, but foreign demand would offset the impact from rising financing costs. Even so, spillovers to emerging markets could also be less benign. Broad-based US wage in- flation or sustained supply bottlenecks could boost prices more than anticipated and fuel expectations for more rapid inflation. Faster Fed rate increases in response could rattle financial markets and tighten financial con- ditions globally. These developments could come with a slowing of US demand and trade and may lead to capital outflows and curren- cy depreciation in emerging markets. The impact of Fed tightening in a scenario like that could be more severe for vulnera- ble countries. In recent months, emerging markets with high public and private debt, foreign exchange exposures, and lower cur- rent-account balances saw already larger mo- vements of their currencies relative to the US dollar. The combination of slower growth and elevated vulnerabilities could create ad- 62 CREDIT MANAGER MAGAZINE LUTY / FEBRUARY 2022 ANALYSIS