U.S. Inflation and Emerging Economies
The coronavirus pandemic and containment measures has devastated the global economy. Under the leadership of the major ones, the central banks of the countries have been trying to heal the wounds of the economies with their enormous expansionary monetary policies, while the governments have involved with various incentives. Most of the central banks especially the FED and the European Central Bank (ECB) has lowered the policy rate to near zero along with other quantitative easing (QE) policies to revive their economies after lockdowns and shutdowns of industries for too long.
The global inflation rate was at low levels even before covid-19, but with the global demand almost disappearing with the epidemic, inflation in many countries fell to historically low levels. After all, since low inflation is usually associated with low demand, low economic growth and therefore unemployment, central banks like the FED and ECB aimed to stimulate the economies with their QE policies and governments with various stimulus packages and focused on the rise of inflation from historical lows that is for the recovery of the economy.
The US economy and its fiscal and monetary policies have stood out for years as vital factors that should be followed and paid attention to for the global economy, especially for developing economies. The expansionary monetary policy implemented by the USA to recover its own economy immediately after the pandemic gave a breath of fresh air to the entire world economy. US inflation gauge jumps as recovery accelerates. However, with the help of the recently accelerated vaccination, the rapid recovery of the country’s economy, the decrease in unemployment, the rise in 10-year treasury bond yields and the rapid increase in inflation caused the tapering rumors to spread through word to mouth.
After the epidemic, the Fed, with its huge expansionary monetary policies, saved the global economy from the verge of a cliff as well as its own economy. Yes, that is right. But now the FED, which will want to hold the reins in its rapidly warming economy, will have to take steps that will only benefit its own economy.
This is where the path of the global economy, and especially the developing economies come to a parting of the ways.
First of all, it is useful to focus on the beginning of the story. Let’s take a look at the effects of the fiscal and monetary policies implemented as of March 2020, right after the epidemic. The FED balance sheet, which was around $4.3 trillion in March 2020, nearly doubled in just 15 months by reaching $8 trillion. With the extraordinary meetings not on the calendar, the policy rate was gradually reduced from 2.75% to 0%-0.25%. Thus, while the US dollar became cheaper, the attractiveness of the US dollar in global markets disappeared and money flow shifted into risky assets, namely currencies and assets of emerging economies. US dollar index (DXY), which had stood at 103 in March, dropped to 89.2 in January 2021, with a loss of around 13.4% with all these QE policies. All of these gave a breath of fresh air to the currencies of EM along with giving the emerging economies extra time to implement their QE policies. The problem is that some emerging economies muffed the opportunity.
FED officials have been saying that they will allow inflation to run somewhat above their 2% target to be able to recover the wounds of the pandemic-hit economy. In other words, they claim that they will not raise the policy interest rate until they achieve their dual inflation and employment mandate. U.S. inflation in April accelerated at its fastest pace in more than 12 years, by rising 4.2% from a year earlier. The hike in the inflation rate was mainly supported by both supply-side bottlenecks and the base effect. That is such a relief but the rate is still way too higher than the target. Various FED officials have claimed that they are largely unconcerned about inflationary pressures, which they see as transitory. It is necessary to keep in mind the FED’s main task is to ensure price stability. For this reason, we find these claims reasonable, but we should not to miss the facts that are going on. Even if the rise in inflation rate is transitory, the data coming from the U.S. economy signals that the pace of the economic recovery is satisfying and the current ultra-loose policy has been worth it.
Some other Fed officials consider that if the economy continues to pick up strongly, it might be appropriate at some point in upcoming meetings to begin discussing a plan for tapering. Even without taking action on tapering, authorities’ statements will negatively affect fragile economies. Unemployment has been on the fall with U.S. President Joe Biden’s stimulus packages along with FED’s QE policies. U.S. officials continue to set the things right and the progressive speculations and expectations on tapering is what emerging economies have to scare of.
It is clear that quantitative tightening policies will not be the case for a year or more. But slowing down the quantitative easing policies, in this case it is to start with tapering, which would easily put a spoke in emerging economies’ wheel. U.S. dollar index is expected to get swole as soon tapering is authorized and applied. This will help U.S. 10-year yield is to keep on rising. Like a snowball effect, these will start a runaway from risky assets to U.S. dollar and that will make U.S. dollar stronger. In other words, most of the EM currencies will suffer. Emerging economies with the cost-push inflation will find it hard to lower both inflation and policy interest rates. Import-driven economies will suffer more. Financing costs of EM will rise. Central banks of EM may have no option but to raise rates.
U.S. inflation and the possibility of tapering are the markets’ key focus at the moment. Even if the U.S. inflation rate hike is transitory, it is crystal clear that we have come to the end of the era when EM were comfortably implementing expansionary policies. Those who have not put their feet on the quilt with the right policies since the pandemic are about to enter a difficult corner. That is why, emerging economies, especially the fragile ones should be worrying more about US inflation than about their own.
