Policymakers in emerging economies should prepare for the U.S. Federal Reserve to start tightening its policies, International Monetary Fund officials cautioned recently.
Most investors anticipated inflation would tick up in the United States due to a shaky pandemic recovery and continuing challenges with the supply chain, according to the authors of "Emerging Economies Must Prepare for Fed Policy Tightening," published Jan. 10 on the IMFBlog website.
However, with prices rising more quickly than in they have in more than 40 years, a weak labor market forcing wage hikes, continuing concerns surrounding the ever-changing COVID-19 virus and the Fed's decision to slow its purchase of assets, the economic outlook for emerging nations looks bleak, according to the article.
"Policymakers may need to react by pulling multiple policy levers, depending on Fed actions and their own challenges at home," the article's authors write.
The blog post was written by Stephan Danninger, chief of the IMF’s Macro Policies Division in the Strategy Policy and Review Department; Kenneth Kang, a Deputy Director in the IMF's Strategy, Policy and Review department; and Hélène Poirson, the Deputy Division Chief in the Macro Policy Division of the Strategy, Policy, and Review Department.
The authors explain that most investors assumed a level of inflation given the somewhat volatile recovery from the pandemic restrictions and the supply chain issues that were causing worldwide issues. However, the assumed level has been far outpaced in reality because prices are increasing at the fastest rate in nearly four decades.
Due to pandemic-fueled spending increases, average government debt in emerging markets is up nearly 10% since 2019, which exacerbates the issues posed by inflation and slower economic recovery and labor market resurgences, according to the authors.
"While dollar borrowing costs remain low for many, concerns about domestic inflation and stable foreign funding led several emerging markets last year, including Brazil, Russia, and South Africa, to start raising interest rates," the authors write.
The authors state the IMF still predicts strong growth from the Untied States and expects inflation to calm down sometime during 2022. A well-structured and communicated response should be harmless for emerging markets, they say. However, lingering supply-chain problems and unforeseen policy changes at the Federal Reserve could rattle global financial markets, the authors write.
"In response to tighter funding conditions, emerging markets should tailor their response based on their circumstances and vulnerabilities," the trio advises. "Those with policy credibility on containing inflation can tighten monetary policy more gradually, while others with stronger inflation pressures or weaker institutions must act swiftly and comprehensively."
Allowing currencies to depreciate and raising benchmark interest rates is recommended in either case. Central banks with adequate reserves can intervene should conditions deteriorate in foreign exchange markets, "provided this intervention does not substitute for warranted macroeconomic adjustment," the authors write.
One of the main focuses for emerging markets should be to reduce individual, internal vulnerabilities to insulate the country from the threat of external economic actions, the authors write. Economic policy should be employed for the same purpose, the authors state, and should be more proactive and tailored to the country's unique financial position.
"While the global recovery is projected to continue this year and next, risks to growth remain elevated by the stubbornly resurgent pandemic. Given the risk that this could coincide with faster Fed tightening, emerging economies should prepare for potential bouts of economic turbulence."