Brace for turbulence

Countries must be prepared for the spillover effects from the Fed's rate hikes

After the outbreak of the COVID-19 pandemic in early 2020, the United States adopted extremely loose monetary and fiscal policies to boost growth. The Federal Reserve lowered the federal funds target rate to the range of 0 to 0.25 percent in a short time, and implemented aggressive quantitative easing, expanding its balance sheet from $4 trillion to $9 trillion.

In terms of fiscal policy, the US federal deficit ballooned to 15 percent of GDP in 2020, mainly as a result of handing out cash directly to low- and middle-income households. Thanks to the stimulus measures, the US economy quickly recovered from the recession brought about by the pandemic.

The unemployment rate stood at 3.6 percent in May, approaching the lowest level in history. But in terms of inflation, the consumer price index reached 8.5 percent and core CPI growth was 6 percent in May, far exceeding the Fed's target level of about 2 percent.

There are several reasons behind the soaring inflation in the US.

Its fast economic growth has outpaced the potential growth rate, its consumption revival came earlier than the recovery of consumption, and the high tariffs imposed on some types of Chinese goods have also been a contributory domestic factor. As for external factors, the surging prices of global bulk commodities, such as food and grain, caused by the Russia-Ukraine conflict, have triggered imported inflation in the US.

Amid robust growth, a labor shortage and high inflation, the Fed was forced to quicken its pace of tightening its monetary policy. On March 16, it raised the benchmark interest rate by 25 basis points; on May 4, it lifted the interest rate by 50 basis points; and on June 15, the Feb increased the rate by 75 basis points, the steepest rise since 1994. In addition, the Fed started shrinking its balance sheet by $47.5 billion per month in June, July and August.

Usually, when the Fed launches an interest rate hike cycle, it will trigger turbulence in the global financial market. Over the past more than half year, the long-term US interest rates have risen sharply, with the 10-year treasury yield approaching 3.5 percent. As the most important benchmark rate in the global financial market, the increase in the long-term US interest rate will push down the prices of global risk assets and safe-haven assets, and lead to the appreciation of the US dollar against other currencies. But sometimes the Fed's interest rate hike creates financial turbulence in emerging economies, and other times, it sparks turmoil in the US financial market.

In the last century, successive interest rate hikes by the Fed led to the debt crisis of Latin America in the 1980s, and the Asian financial crisis of 1997-98. That is because typically, when the Fed starts a rate-hike cycle, the interest-rate gap between the US and emerging economies will narrow, provoking an outflow of capital from emerging markets to the US.

Under such circumstances, emerging economies face slumping asset prices, currency depreciation and rising foreign currency debt. If dealt with improperly, that could spark a monetary crisis, debt crisis or a financial crisis, or even an economic crisis. For example, when the Feb announced its plan to end its loose monetary policy in 2003, some emerging markets were plunged into financial turmoil.

It is noticeable that the Japanese yen has tumbled against the greenback recently, with the exchange rate dropping to around 135 yen against the dollar. The sharp depreciation of the yen could cause negative impacts on export-oriented emerging economies which have a trade structure similar to that of Japan, and even lead to depreciation of the currencies of these economies against the US dollar.

At home, the US internet bubble in 2000 and the housing bubble in 2007 also burst after the Fed raised interest rates multiple times. The logic behind the collapse is that if the US capital market or housing market is overvalued, the Fed will launch a rate-hike cycle to increase lending costs, which will push down asset prices dramatically, thus triggering a financial crisis.

In addition to 2000 and 2007, the Fed's rate hikes from 2015 to 2017 wiped out about 20 percent in value from the US stock market in 2018. Since the beginning of this year, the three major US stock indexes have fallen by around 20 percent－the threshold of a bear market. And more turbulence in the stock market is expected for the remainder of this year, and the possibility of a slump cannot be excluded.

So, will this round of Fed's interest rate hike send shock waves to emerging economies or to the US financial market? The answer remains unclear. But the combination of the Russia-Ukraine conflict and the Fed's rate hikes may pose a severe challenge to the world economy, with the threat of stagflation looming large. The steep rise in the US interest rates will have enormous impacts on the financial markets of both emerging economies and the US.

How should emerging economies such as China respond to the challenge?

To weather growing external influences, emerging economies should first stabilize their economic fundamentals and maintain steady growth. It is also important for them to prevent their current account deficit from ballooning, which can put local currencies under huge depreciation pressure. Moreover, emerging economies should allow their currency's exchange rate against the US dollar to fluctuate within a reasonable range in order to resist and mitigate negative external influences.

Besides, emerging economies should properly control capital flows to prevent the vicious circle between massive capital outflows and currency depreciation expectation. Last, emerging economies should take precautions to better prepare for a possible crisis.

The author is deputy director of the Institute of Finance and Banking at the Chinese Academy of Social Sciences and deputy director of the National Institution for Finance and Development. The author contributed this article to China Watch, a think tank powered by China Daily. The views do not necessarily reflect those of China Daily.

Contact the editor at editor@chinawatch.cn