There are many ways the shift in Fed policy could cause trouble, but Lagarde said she feels confident that some of the most likely problems can be avoided. Developing nations in the past, for example, have been subject to fiscal and economic shocks when U.S. interest rates rise sharply and investors begin pulling money out of riskier places.
But “the world has changed,” Lagarde said, and key emerging markets “have strengthened their fundamentals to such an extent that I don’t think they would be victims” as the Fed shifts gears. The IMF, she noted, had also changed its approach on how possible problems could be managed: Long an advocate of the free flow of capital around the world, the fund changed its stance and said that temporary capital controls were a reasonable way for countries to protect themselves.
She suggested that countries could clamp restrictions on the movement of capital if future Fed actions prompt investors to begin pulling money from developing world markets.
Her comments come at a sensitive time in the world economy as companies, investors and households prepare for the end of a five-year era in which the Federal Reserve has served as a sort of firefighter-in-chief to support economic growth. Interest rates have been kept at historically low levels, and the Fed has bought trillions of dollars in financial assets to keep the economy afloat.
The fund in recent months has been trying to understand what might happen next and got a preliminary taste last week when Federal Reserve Chairman Ben S. Bernanke said the central bank may start reducing its $85 billion monthly asset purchases as soon as this fall.
The days that followed showed just how topsy-turvy the world has become. Although Bernanke said that Fed “tapering” was actually a sign that the economy was doing well, investors fled from equity markets and drove up the value of safe haven U.S. Treasury bonds.
On Wednesday, a poor report on U.S. economic growth — usually bad for markets — triggered a 1 percent rise in the Dow Jones industrial average because it suggested that Bernanke might keep the Fed’s monetary spigot open longer.
Regardless of when it starts or how long it takes, the withdrawal of the Fed from asset markets is likely to mean an unpredictable couple of years as monetary policy returns to normal, analysts from ING wrote in a paper looking at how Bernanke’s announcement has influenced markets already.
“Scope for disaster — broad,” the paper proclaimed, as it marched through the possible problems that could be touched off as the Fed pulls back — from a renewal of the debt crisis in Europe as global interest rates rise and stress the finances of Spain and Italy, to the failure of a company or hedge fund badly positioned for such an increase.
“At some stage, something will go ‘bang.’ . . . The field for potential catastrophe is a wide one,” the analysts wrote.
A new Institute of International Finance study of global capital flows predicted a sharp downturn in capital flowing to emerging markets in the coming year, as investors adjust to slowing growth in those countries, possible higher returns on U.S. Treasurys and an overall reassessment of risk.
U.S. Treasury bonds are an important reference point for investors worldwide, considered among the few places where pension funds or insurance companies can place money on a “risk-free” basis. If they also start paying a more reasonable return, the attraction will become even greater, pulling back investors that had sought higher returns in Europe or the strongest developing nations.
Bernanke’s statements are the “first step in bringing rates and the Fed’s balance sheet back to some historical balance,” said Hung Tran, managing director of the Institute of International Finance, an association of the world’s major financial institutions. “It is normalization, but it will be a long period during which there will be a high level of uncertainty.”