Emerging markets think the Fed is causing bubbles. The Fed disagrees!

November 5, 2013

Go to the finance ministry or central bank of any number of emerging economies -- think Brazil, Indonesia, South Africa -- and you'll hear a common refrain: The Federal Reserve is making our jobs really hard.

There is a widely held view that by printing trillions of dollars and keeping U.S. interest rates near zero, the Fed is essentially creating hard-to-manage bubbles across the developing world. The logic goes like this: Investors feel like they can't earn any return on U.S. Treasury bonds, because the Fed is buying them all up and depressing interest rates, so they must turn to assets in Mexico or Turkey or wherever, creating a gush of hot money into those countries that threatens to unravel as soon as the Fed relents.

But what is the view inside the Fed of this theory? We have the most thorough take on it to date Monday, via a new speech by Governor Jerome Powell at the San Francisco Fed's Asia Economic Policy Conference.

In short, it boils down to this: Yeah, we know that our actions create some challenges for you guys. But mostly you need to look in the mirror, Mr. and Ms. Emerging Markets.

Of course, Powell is more polite than that. But here's how his argument breaks down.

First, he argues that if U.S. interest rate policy were the dominant driver of flows into emerging economies, then money flowing into those nations would predictably rise whenever the gap between emerging market interest rates and U.S. interest rates rises, and fall when it falls. As Powell puts it, "at times, this is indeed the case: From mid-2009 to early 2011, the interest rate differential and EME capital inflows rose together. But the overall relationship is not particularly tight. In early 2007, capital flows to EMEs were quite strong even with a low interest rate differential. And in mid-2011, capital inflows stepped down even as the interest rate differential remained elevated . . . the lack of a tight relationship between capital flows and interest rates suggests that other factors also have been important."

What are those other factors driving the gush of money into emerging economies? One is simply their superior growth rates over the last decade. Of course people want to invest in fast-growing economies. This chart shows the relationship between growth rates and capital inflows:


And a related factor driving the ups and downs of capital flowing into these countries is the overall sense of risk among investors. When the financial world seems about to implode, like in the fall of 2008, they pull money out of the "risky" emerging markets, and when things seem benign, they're more likely to pour money in.

That's what the chart below shows. The Vix is a measure of expected U.S. stock market volatility in options markets. It correlates remarkably well with emerging market capital inflows.


So Powell is arguing that while the Fed's interventionism does have an impact on the emerging economies, broader factors of market psychology and the real economy are driving the train.

And finally, Powell argues against the notion that these capital inflows that emerging markets face are a uniform negative for them. A common criticism is that an inflow of investment dollars drives up the value of currencies in the emerging world, making their exports less competitive and damaging domestic growth.

Fair enough, Powell says, but you also have to weigh that against stronger U.S. demand caused by the Fed's easy money policies. Yes, a Thailand or Malaysia might have a stronger baht or ringgit due to Fed interest rate cuts. But they also have more demand for their products from American consumers.

"Even if advanced economy monetary policies were to put upward pressure on [emerging market] currencies," Powell said, "the consequent drag on their exports must be weighed against the positive effects of stronger demand in the advanced economies. According to simulations of the Federal Reserve Board's econometric models of the global economy, these two effects roughly offset each other."

Powell's view, which seems to be widely held in the Fed system, boils down to this: We get it, friends in the developing world. And we're watching it. But we don't think we're the major drivers of the hot money you're trying to grapple with.

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