Why Fed action matters more to developing markets than their own central banks

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Everyday regular people around the world wake up, go to work, come home and go to sleep. They are touched by governments on a daily basis for many things. Governments build roads and bridges, maintain mass transportation, tax goods and provide other services like health care.

Governments can seem like the most important influence on a person's daily life, but what if they are not? What if there are more important actors in a person's day-to-day life that they are unaware of? What if other governments influence their lives just as much as their own, if not more? In a newly released paper by Matteo Iacoviello and Gaston Navarro titled "Foreign Effects of Higher U.S. Interest Rates," the evidence is clear that the U.S. Federal Reserve plays a major role in the lives of practically everyone worldwide.

The authors begin the report by mentioning previous literature which looked at specific time periods for only a few countries. They say that they "rely on a comprehensive dataset containing observations on quarterly GDP and time-varying country characteristics for 50 foreign economies for over 50 years." The paper presents three important results. The first and most fundamental result of the paper is that the "foreign spillovers of higher U.S. interest rates are large."

In fact the effects of a Federal Funds rate hike by the FOMC (Federal Open Market Committee) of the Fed are on average as large overseas as they are within the United States. Specifically, a rate hike of one percent equals about a cut in GDP of between 0.5 and 0.8 percent in the three years after the hike. U.S. GDP is cut by about 0.7 percent in the following two years.

The second result of the paper, "In advanced economies, higher U.S. interest rates are transmitted through standard exchange rate and trade channels," illustrates the immediate and direct impact of a rate hike on the exchange rates of foreign countries. The more closely the two currencies are correlated or the larger the trade volume between the two countries, the response to the hike in advanced economies is that much greater.

Finally and most importantly for countries like Turkey, emerging markets are not effected in the way previously theorized. While a rate hike would result in an appreciation of the U.S. dollar thus making American goods more expensive and foreign goods more competitive, this event "explains little of the differential GDP responses within economies" according to the authors. The differential GDP responses are instead explained through a country's "financial fragility." The authors then construct a "vulnerability index" made up of "current account, foreign reserves, inflation and external debt."

The paper concludes with discussion of the data and methodology. The most important take away is that "trade and exchange rate exposure to the United States do not seem to matter." Essentially, countries that are less fragile are also less vulnerable to the effects of a rate hike by the Federal Reserve. So while trade with the United States and relationship with the dollar may seem important the financial health of a country seems to be much more important in weathering financial storms brought on by tightening of monetary policy.

Turkey seems most vulnerable to exogenous interest rate hikes through the "inflation" index and how GDP responds in emerging market countries with high inflation. By contrast trade with the United States, foreign reserves, and even current account deficits don't matter nearly as much as inflation and external debt components.

So how should Turkey and other emerging markets best immunize themselves from interest rate hikes that the Federal Reserve may implement? The authors note that those best able to do so are countries "that succeed in keeping their financial house in order." Obviously the final sentence in the paper is easier said than done.

Democracies aren't run by economists with long-term objectives but rather by people who are looking to better their lives in the short run. Keynes' famous quote on the topic, "In the long run, we are all dead!" summarizes the issue perfectly. Convincing populations to take necessary medicines for long-term financial health will not always be easy and will never be popular.

Perhaps the greatest takeaway from this paper for American policymakers is the implications of their actions on global financial health. In this era of globalization a decrease in demand overseas very much impacts the U.S. economy and therefore U.S. policymakers need to tread lightly before executing data-independent ideological tightening experiments like the one we currently find ourselves in.

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