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The effects of U.S. policy normalization on global central banks

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The U.S. Federal Reserve (Fed) is set to embrace modestly higher interest rates during the next three years, in a slow and orderly fashion, which takes into account the global economy, dollar appreciation and disinflation. The September Fed decision to postpone the fi st step in policy normalization shows that the central bank is taking into account global financial and economic conditions. However, improvement in the U.S. labor market and economy during the past two years means the probability of a rate increase this year remains high, even with the recent volatility in global asset markets.

MIDDLE MARKET INSIGHT: The recent decision by the Fed to postpone the first rate increase, possibly even until 2016, means that middle market firms concerned about tightening financial conditions and the higher cost of capital have more time to prepare for a shift in the global financial landscape.

The onset of much stronger growth in the U.S. economy, which will help offset falling demand for exports from emerging markets and developing economies, as well as aggressive monetary policy put in place by the European Central Bank (ECB) and the Bank of Japan, should combine to provide a global economic and liquidity buffer, as the Fed embarks on its rate hike campaign.

While investor fears of a repeat of the rapid 140 basis-point increase in the U.S. 10-year Treasury yield between May and December 2013 (the so-called “Taper Tantrum,” according to U.S. media), or of a repeat of the 1994 to 1995 rate hikes that some associate with the series of banking and financial crises that followed, are understandable, in our view, the probabilities of a similar development are overstated.

MIDDLE MARKET INSIGHT: Global middle market firms should experience rising demand, as advanced economies expand, even as policy normalization in the United States and U.K. occurs. However, firms should still prepare to face tighter financial conditions inevitably, once this phase of the U.S. business cycle ends.

stead, if long-term U.S. Treasury yields rise by 100 points during the first six months after the first rate increase (an outlier in our opinion), developing economies that run large, current account deficits, or whose exports of oil and commodities account for outsized proportions of growth, would likely see an increase in capital outflows of between 0.5 percent and 0.8 percent of gross domestic product. That is less than one standard deviation from the norm, which is inconsistent with a global economic crisis. In other words, the upcoming rate hike campaign will not resemble that unleashed by the Fed when former chairman Alan Greenspan increased the policy rate by 300 basis points over a 13-month period, between 1994 and 1995.

It’s important to note that the Fed ended its asset purchase program in October 2014, and since that time, the U.S. 10-year Treasury yield has averaged 2.13 percent, only two basis points below its current level, and well below the 2.44 percent averaged between 2013, and the end of the Fed asset purchase program. Thus, the probability of a global adverse monetary shock emanating from the United States has diminished. Moreover, while emerging market yields remain higher than before the so-called “Taper Tantrum,” there are no signs of credit risk, funding stress or general counterparty risk that implies global systemic risk. (See Global Financial Conditions Watch in this issue).

The Fed’s liftoff may be delayed by global financial turmoil, but it will not be denied. The economic slowdown in China and the knock-on effects to emerging markets, in addition to falling oil and commodity prices, will take a period of a year or more to unwind. Fed policy is now tied to improvement in those markets. The U.S. central bank is clearly signaling to global investors and forward-looking firm managers that it will take into account global financial conditions when setting policy.

We anticipate the Fed will lift the policy rate by 25 basis points this year, followed by another 50 to 75 basis points early next year, before the central bank holds until after the 2016 U.S. presidential election.

Then, in 2017 and 2018, the central bank will likely get more aggressive and move rates higher in the wake of what will have been a multiyear period of above-trend (2 percent) U.S. growth. The Fed’s own forecast implies that the policy rate should increase by about 250 basis points by the end of 2017; although, given the demographic and technological headwinds facing the U.S. economy, a move to 200 basis points in the policy rate is probably more likely.

For global central banks, this poses a challenge. For developed, emerging markets and developing countries that run current account surpluses and have flexible exchange rates, a gradual and orderly rate increase campaign should be relatively easily absorbed. For these economies, as conditions improve and monetary accommodation eases, demand for exports should increase. Once the fl  or in oil and commodity prices is found, their period of adjustment should be short. Economies such as Mexico, for example, which is engaged in a period of economic reform, and India, which has taken steps to liberalize domestic markets and narrow current account deficits, are in far better shape to adjust to U.S. policy normalization than others.

Economies that have large current account defi   ts, and which are therefore holding signifi  ant quantities of dollar- denominated debt, or which maintain pegged exchange rates, the near- and medium-term transitions will be challenging. Under conditions of a sharp increase in rates in the United States, eurozone, U.K. and Japan, this would result in falling equity prices, slowing or shrinking industrial production, and currency depreciation and would put the central bank in the unenviable position of being forced to raise interest rates at the worst possible time.

This may be particularly challenging for economies that are overly dependent on oil and commodity exports that would create possible monetary and fiscal shocks associated with dollar appreciation, causing the cost of oil to fall further and commodities with it. Many of these economies have deteriorated over the past year and experienced large currency depreciations independent of Federal Reserve policy. Under such conditions, capital outflows would increase and currencies depreciate sharply, causing central banks to hike rates and fiscal authorities to pull back on outlays. Economies such as Brazil, Malaysia, Russia, South Africa, Turkey and Venezuela could come under significant pressure.

Fortunately, only the United States is contemplating a rate increase this year. The Bank of England will likely wait until mid-2016, and the European Central Bank (ECB) and Bank of Japan will not be raising rates for a number of years. In fact, our estimation of the ECB’s reaction function, which explains how the central bank alters policy in response to changing economic conditions, implies that the central bank will remain accommodative for far longer than it currently has signaled to investors. We anticipate its balance sheet will grow to about €4.2 trillion euros, far higher than the official policy goal of €3 trillion.

So what are monetary and fiscal authorities to do in developing markets over the medium term, where risk of a monetary shock lies? First, reductions in dollar- denominated and short-term debt is of the essence. Second, creating more stable monetary conditions by hitting inflation targets would buttress policy credibility. This is critical, because policy credibility tends to reduce the necessity or pace of interest rate hikes to avoid overdepreciation of national currencies. Third, undertaking structural reform, putting primary budgets on a path to balance and putting in place policy incentives to diversify economies away from an overreliance on oil or a narrow range of commodities would bolster policy credibility. India and Mexico are two economies that have profited from the imposition of structural changes over the past few years. Fourth, maintaining exchange rate flexibility, but being willing to take reasonable and targeted support measures can shore up currency or slow depreciation. In periods of global economic change, adjustment via the currency channel remains one of the effect mechanisms to cushion transitions and provide outlets for growth.


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