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Monetary policy lift-off in the United States: so far only a moderate impact, but emerging markets should brace themselves

Press Release of April 15, 2016

DIW Berlin claims that the US Federal Reserve’s decision to end its zero interest-rate policy has not caused turbulence in financial markets

According to a recent analysis conducted by the German Institute for Economic Research (DIW Berlin), the interest rate lift-off introduced by the US Federal Reserve at the end of last year has not led to distortions in the financial markets. Financing costs in emerging countries like Mexico and Brazil have been only slightly higher since the rate hike; sudden capital outflows or a fire sale of assets failed to materialize, contrary to initial fears; and even interest rates on the US national debt are hardly higher than they were last year.

German Institute for Economic Research (DIW Berlin)

The German Institute for Economic Research (DIW Berlin) is one of the leading economic research institutions in Germany. Its core mandates are applied economic research and economic policy advice as well as provision of research infrastructure. As an independent non-profit institution, DIW Berlin is committed to serving the common good. The institute was founded in 1925 as Institut für Konjunkturforschung (Institute for economic cycle research). Since 1982, the Research Infrastructure SOEP (German Socio-Economic Panel Study), a long-term study, is affiliated to DIW Berlin. The institute has been headquartered in Berlin since its founding. As a member of the Leibniz Society, DIW Berlin is predominantly publicly funded.

“It is reassuring to see that the interest rate reversal in the US has not caused any major turbulence,” says DIW monetary policy expert Christoph Große Steffen.

Numerous economists had predicted that emerging economies would be hard hit if the change caused their currencies to drop against the dollar, which would raise prices on imports and make loans denominated in US dollars harder to repay.

So far, this has in fact been the case—though not to a great extent. According to Große Steffen, it helped that the US Federal Reserve had planned the lift-off well in advance, which gave the financial markets time to prepare. In addition, explains Große Steffen, the phase-out of the extremely loose monetary policy was initiated because of a sustained recovery and a pickup in growth in the US economy—and this relatively robust US economy benefits emerging countries, because it allows them to sell more of their products on the US market.

Nevertheless, Große Steffen advises emerging economies to prepare for further rate hikes. This applies particularly to countries with high current account deficits that import more goods and services than they export. The financing of the current account deficit will become increasingly difficult due to the fact that the US has just begun a more restrictive monetary policy cycle that could lead to further currency depreciation and capital flow reversals. Capital buffers should therefore be used and credit growth adjusted in the private and public sector.

Central bank’s communication strategy plays an important role

At the end of this past December, the US Federal Reserve decided to end the zero interest-rate policy that had been in place since the financial crisis and to slightly raise the federal funds target rate (by 0.25 percentage point) for the first time in roughly ten years. The central bank’s communication strategy played an important role here: because the markets were expecting the rate hike, their reaction was calm—unlike in the spring of 2013, when the Chair of the US Federal Reserve unexpectedly speculated about the end of the US’s bond purchase program, thus creating turmoil in the markets.

Further rate hikes are planned if the US economy continues to grow and inflation picks up again—but exactly how and when this will take place is difficult to predict, with the result that there is still substantial uncertainty surrounding the path and timing of US monetary policy. To prevent the financial markets—particular those of the emerging countries—from being caught off guard, Große Steffen advises supplementing the Fed’s communication strategy to reduce the uncertainty related to the upcoming rate hikes.

“The fact that the investors are investing more in the US and less in the emerging countries when the US interest rates keep increasing is inevitable,” he explains. “Therefore, it is all the more important that countries prepare themselves for capital outflows and deteriorating financing conditions.”

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