Javier Guzmán Calafell: The normalization of monetary policy in the
United States - challenges for emerging market economies
Remarks by Mr Javier Guzmán Calafell, Deputy Governor of the Bank of Mexico, during the
panel on "Central banks' policies: the new normal in monetary policy, the USD and
implications for emerging market", at the 21st Reserve Management Serminar, organized by
UBS AG, Ermatingen, Switzerland, 16 June 2015.
* * *
The views expressed in this document are strictly personal and do not necessarily coincide with those of Banco
de México's Board.
I am very honored to have the opportunity to participate in this Conference. I thank the
organizers for the invitation to share with this distinguished group my views on some of the
challenges that emerging market economies (EMEs) will be facing as monetary policy in the
United States is normalized.
EMEs displayed a remarkable performance in the years that preceded the global financial
crisis. During 2000-2007, real GDP growth for the group as a whole was more than double
that observed in the advanced economies, while also showing a significant acceleration with
respect to the 1990s.1 Furthermore, emerging economies recovered quickly from the adverse
impact of the crisis, with growth peaking in 2010 at a pace, again, more than twice as much
as that in the advanced economies.
Ever since, however, the pace of economic activity in EMEs has been continually declining,
with growth in 2015 expected to mark the fifth consecutive year of deceleration. This has
been the result of a number of factors, chief among them lower rates of actual and potential
growth in the advanced world; the continued slowdown in China, as the economy transitions
towards a more sustainable growth path and the sources of demand rebalance; the end of
the commodity price boom, and particularly the sharp fall in oil prices, that has adversely
affected the terms of trade of many of these economies; and the emergence of internal and
external vulnerabilities, as well as supply side constraints, in a number of countries of the
group.
With the expectation of an increase in interest rates in the United States as monetary policy
in this country normalizes, external conditions for emerging economies are unlikely to make a
turn for the better in the foreseeable future. In fact, we are already witnessing a tightening of
global financial conditions, and net private capital inflows for the group as a whole are
expected to fall in 2015 to the lowest level since 2009.2 While this is the result of a
combination of factors, including the situation in Greece and problems of a geopolitical
nature, the prospect of an upward trend of interest rates in the United States seems to be
playing a major role. In this context, the date of the first increase in the federal funds rate has
become one of the main issues of concern for both market participants and emerging market
economies' authorities.
The process of monetary policy normalization in the United States is surrounded by a
significant amount of uncertainty. The Federal Reserve has made clear that adjustments to
the federal funds rate will depend on the evolution of the economy, and particularly on further
improvement on the labor market and reasonable prospects that inflation will move back to
its 2 percent objective over the medium term. However, as a result of a combination of
factors, assessment of both the underlying strength of the labor market and of inflationary
pressures is particularly difficult under current circumstances. Furthermore, the impact of
normalization on emerging market economies is also uncertain, as is the possible timing of
such impact, especially since markets are likely to anticipate such a move. Federal Reserve
officials have insisted that rather than the date of the first increase, the focus should be on
the subsequent pace of interest rate adjustments, which is expected to be gradual.
Nevertheless, thus far this has been of little help to calm market and emerging countries'
anxieties.
The above concerns are understandable when put against the recent experience.
First, as advanced economies engaged in a process of monetary policy easing and
international interest rates dropped to historical minima in the aftermath of the global financial
crisis, a surge in foreign capital inflows to EMEs was observed. Three features of these flows
are particularly relevant:3 a) they represented a major redirection of capital flows towards
EMEs, which implied that the latter received close to half of global flows between 2010 and
2013, quite far from what fundamentals in those economies could explain; b) contrary to the
experience of the preceding period, portfolio flows gained an increasingly important share;
and c) in an environment of strong appetite for risk, EMEs issuance of below
investmentgrade debt jumped swiftly. Furthermore, as a side effect, such inflows gave rise to a
significant appreciation of real exchange rates and a rapid expansion of credit, including
through the shadow banking system, in many EMEs, thus increasing their vulnerability.
Second, the "taper tantrum" episode of 2013 provides further evidence on the significance
that spillovers from shifts in monetary policy in the advanced economies, even when they are
only perceived and do not actually occur, can have on emerging markets. Expectations of an
unwinding of the unconventional monetary policy implemented in the United States led to a
strong market reaction during that period. Consequently, financial volatility rose sharply and
capital flows to EMEs fell, leading to pressures on the exchange rates and asset prices in
these economies, increased external risk premia, and in general a severe tightening of
financial conditions. Some authors have stressed the significance of financial market turmoil
during May-August 2013, despite the relatively small decrease in capital flows to EMEs
(about 1% of GDP).4
It is of course natural to ask to what extent the above experiences are applicable to the
current situation. In other words, is the normalization of monetary policy in the US likely to
have a major impact on EMEs? Here we have divergent views.
On the one hand, there are those who believe that the outlook for emerging market
economies is not as gloomy as it seems:
• The upcoming tightening cycle will most likely take place within the context of a
firmly established recovery in the United States, which is a scenario that has seen
emerging market economies thrive in the past. As a reference, some estimates point
out that, over the year following the beginning of the last three tightening cycles in
the United States, industrial production in emerging markets grew between 7.5%
and 10%, while export volumes did so by some 10% to 15%.5 All in all, the argument
goes, higher interest rates in the United States associated to a stronger economy in
that country are a net positive for emerging market economies.
The ongoing efforts from the part of the Federal Reserve and other central banks in
•
the advanced economies in terms of their communication with the public and the
transparency of their decisions, are expected to play a key role on how markets
react and emerging economies are affected as monetary policy in those economies
goes back to normal. As evidence in support of this argument, it is noted that
anticipated interest rate increases by the Federal Reserve have been followed by
minor pullbacks in capital inflows to emerging markets, while the impact of
unanticipated moves has been much larger.6
• After years -and perhaps decades in some cases- of continued policy efforts in
some key areas, emerging economies in general are today more resilient than they
were in the past to external shocks.
On the other hand, there are also compelling arguments calling for extra caution going
forward, as international financial markets adjust to monetary policy normalization in the
United States:
• Unconventional monetary policies affect financial markets in a way that differs from
the more conventional interest rate policy, and the extent of such difference is
largely unknown. For instance, the large-scale asset purchase programs deployed
by the Federal Reserve and other central banks in advanced economies have
affected global interest rates along the yield curve through a significant compressing
effect on bond risk and term premia, something that does not necessarily follow from
changes in short-term interest rates.7 Thus, there is a risk that such premia, and
particularly the term premium, quickly decompress, giving rise to an abrupt
adjustment of long-term interest rates as the Federal Reserve begins to tighten.
• The marked divergence in the expected path for the federal funds rate between that
implied by market instruments (such as federal funds futures or overnight indexed
swaps) and that obtained from FOMC projections and forecasters surveys,
increases the possibility of surprises and sharp adjustments in financial markets.
• The share of the nonbanking sector in the intermediation of international credit has
risen substantially after the crisis, with the growing role of the asset management
industry being particularly noteworthy. It has been noted that this kind of investors
may be more prone to herd behavior, and therefore EMEs may be facing an
increased risk of contagion during episodes of financial turbulence.8
It is of course impossible to determine ex ante which of these views is correct. As far as I'm
concerned, the conclusion is obvious. In the face of an uncertain scenario with very high
potential costs, it is far better for policymakers to err on the side of caution. Therefore, a
close look at the factors that in the past have contributed to alleviate the difficulties resulting
from similar episodes is clearly warranted.
Several elements stand out in this respect.9 First, at the onset of an external shock of this
nature, markets respond rather indiscriminately towards emerging market economies as a
group, with differentiation following after a relatively short time span. Secondly, differentiation
is made on the basis of the strength of economic fundamentals. In particular, economies with
stronger external and fiscal accounts, lower inflation, more international reserves, and sound
and deep financial sectors, to name a few, normally experience more subdued market
reactions. This also underlines the importance of building policy buffers during favorable
times. Third, markets reward timely and credible policy action, as economies that respond to
emerging challenges in a flexible way and with appropriate instruments generally fare better.
Fourth, even though using the foreign exchange rate as a shock absorber has proved
effective in helping emerging economies to better endure a tightening of global financial
conditions, intervention in this market may be useful to cope with temporary bouts of volatility
in a situation of adequate international reserves and an exchange rate which is not
overvalued; however, the effectiveness of intervention tends to disappear when the degree of
market uncertainty reaches very high levels. Finally, growth potential is another major
element of differentiation during episodes of turbulence; more specifically, the better the
prospects for growth the less severe the likely consequences of financial turmoil.
Undoubtedly, putting in practice the above lessons will determine to a great extent the
success of emerging market economies in coping with the possible turbulence that lies
ahead. However, I would like to emphasize that advanced economies are not exempt from
responsibility in this respect.
Federal Reserve officials have repeatedly noted that promoting growth and stability in the
United States is the most important contribution the Federal Reserve can make to the global
economy, and that this is precisely the focus of monetary policy in this country.10 They have
also stressed the need for effective communication to limit the risk of surprises and the
possibility of abrupt market responses.
I have no quarrel with these arguments, and I believe there is widespread recognition of the
major efforts undertaken by the Fed to increase transparency and communication in recent
years. However, I see room for further action from advanced economies in at least three
areas.
First, unconventional monetary policies, though fundamental to overcome the global financial
crisis and underpin the recovery of demand in recent years, provide only a temporary
stimulus to economic activity. Ensuring adequate and sustained rates of growth implies the
adoption of measures focused on enhancing efficiency and productivity that go well beyond
the reach of monetary policy. Indeed, there is a lot that advanced economies still need to do
to meet these needs.
Second, actions taken by major central banks have important consequences for other
economies which deserve careful consideration. Yet, an adequate understanding of such
spillovers is still lacking. Although literature on the subject is scant and definitive conclusions
are difficult to arrive at, to have an idea of the challenges we are facing, it may be useful to
note that recent research carried out at the BIS concludes that US quantitative easing has
had a greater impact on emerging market economies than on the US economy itself.11
Greater awareness among advanced economies of the consequences of their monetary
policy actions would be a major step forward for a more productive dialogue with EMEs.
Third, the room for expanding international cooperation is wide. The strengthening of the
global safety net is a key area in this respect. The creation of a permanent and broad
network of bilateral central bank swap facilities; the conclusion of the still pending IMF reform
and the deepening of efforts in this direction, to provide the institution with proper resources
and more legitimacy in its decision making; and greater collaboration between multilateral
organizations and regional financial arrangements, should clearly be part of these
endeavors. While some of these tasks need the involvement of both emerging and advanced
economies, the crucial role of the latter is evident.
I would like to conclude my intervention by stressing that, beyond the challenges resulting
from the beginning of the cycle of interest rate increases in the United States, emerging
market economies will face a less favorable external environment in coming years. On the
one hand, potential growth in the main advanced economies and China has declined and the
prospects are not very encouraging either. As a result, emerging economies as a group will
probably be facing a weaker demand for their exports, and thus further pressures on their
external and fiscal balances. Furthermore, and related to this, the projected evolution of
commodity prices in the medium and long term implies a deterioration of the terms of trade
for an important subset of these economies, vis-à-vis the levels that existed before the global
financial crisis. Lastly, in the face of a gradual but very prolonged increase in interest rates in
the United States, conditions of access to external financing will tighten. It is clear, then, that
the deterioration of external conditions should not be seen as a short term phenomena, and
that EMEs should strengthen their domestic sources of economic growth. This implies
ensuring macroeconomic and financial stability, the timely tackling of any potential sources of
vulnerability, both internal and external, and the implementation of any structural reforms
required to encourage investment and productivity growth.