IMF: Rising rates, emerging market slowdown could dampen global growth

A new report by the International Monetary Fund underscores the high stakes facing the Federal Reserve as it meets Tuesday in Washington to debate how to unwind years of stimulus that have propped up not only the U.S. recovery but also the world economy.

The IMF pointed to a rocky return to normal policy by the Fed, as well as the Bank of England, as one of the main threats to growth over the next two years. That could reduce output in the United States and the United Kingdom as much as 2 percent through 2016, according to the IMF’s analysis. Volatility in these advanced economies could ripple through some emerging markets, similarly depressing their growth.

“Normalization will carry far-reaching spillovers depending on how the recovery evolves and how well an asynchronous policy exit can be managed given the challenges involved,” the IMF said in its report.

The Fed is in the midst of reducing the amount of money it is pumping into the U.S. economy and plans to end the program in October. Then it will begin considering when to raise its target for short-term interest rates, which have been at zero for six years. That process is untested, unprecedented and fraught with uncertainty -- all of which means markets could be in for a bumpy ride. The IMF pointed to the abrupt spike in U.S. interest rates and rapid outflow of capital from emerging markets last year after the Fed suggested it could reduce stimulus faster than expected as an example of the turmoil a misstep could cause.

For the most vulnerable developing countries -- such as Indonesia and Turkey -- the IMF estimated growth could be as much as 9 percent below its baseline estimates if the worst-case scenarios become reality. The first blow would come from higher interest rates and tighter global financial conditions if the Fed and Bank of England move more quickly than expected. But over time, larger declines would come from lower productivity, weaker trade and falling commodity prices.

In other words, tighter monetary policy in the United States and the United Kingdom could hit just as emerging market economies are slowing down, potentially amplifying the impact. Lower growth in developing countries may then dampen the recovery in advanced economies, creating a negative feedback loop. Those dynamics could lower global output by 2 percent over the next five years, the IMF estimates.

“We do see key risks, both with respect to normalization and to emerging market growth,” said Hamid Faruqee, a division chief in the IMF’s research department and one of the authors of the report. “There really isn’t anything that prevents those two things happening at the same time.”

Source: International Monetary Fund
Source: International Monetary Fund

Of course, rising interest rates are not always a bad thing. In the United States, the economy has regained all the jobs lost during the recession. The unemployment rate has fallen from a peak of 10 percent to 6.1 percent last month, while inflation has remained particularly low. Those factors have convinced the Fed that the recovery is getting closer to being able to stand on its own. Stronger and more sustainable U.S. growth is one of the bright spots in the world outlook, and the IMF expects that unwinding stimulus from the Fed and at the Bank of England will be relatively smooth.

At the Fed, officials have tried to assure markets that they will communicate their plans as they take shape.

“We are very attentive to unfolding economic developments and understand that there can be surprises and twists and turns in the road,” Fed Chair Janet Yellen said at a press conference after the central bank’s June meeting. “I’m personally committed to communicating with the public whenever communication is appropriate.”

Ylan Q. Mui is a financial reporter at The Washington Post covering the Federal Reserve and the economy.
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