Head of the New York Fed acknowledges that the institution has a special duty of care for the whole world
By Ambrose Evans-Pritchard
7:37PM BST 20 Apr 2015
An employee works in a foreign exchange office in central Cairo. The IMF has warned of a 'cascade of disruptions' for the global financial system if US rates jump suddenly
The US Federal Reserve will do its best to avert a bloodbath for emerging markets as it prepares to raise interest rates for the first time in eight years, but warned that it cannot let inflationary pressures take hold in the US itself.
Bill Dudley, head of the powerful New York Fed, acknowledged that the institution has a special duty of care for the whole world, vowing to act with caution to soften a potentially brutal squeeze for borrowers holding record levels of dollar debt outside the US.
"The normalisation of US monetary policy could create significant challenges for those emerging market economies that have been the recipients of large capital inflows in recent years," he said.
"We at the Fed take the potential international implications of our policies seriously. In part, this is out of simple self-interest, since the international effects of Fed policies can spill back onto the US economy and financial markets. In part, too, it reflects a sense of special responsibility we have given the dollar’s role as the international reserve currency."
The assurances came after the International Monetary Fund warned of a "cascade of disruptions" for the global financial system if US rates jump suddenly and there is a further surge in the dollar.
US Federal Reserve
Jose Vinals, the IMF's head of capital markets, said last week that the world is entering uncharted waters as Fed prepares to pull the trigger, warning of a "super taper tantrum" that could inflict even more damage than the original Fed-induced taper tantrum in May 2013.
That episode set off an exodus of capital from countries with big current account deficits, notably the "Fragile Five" of India, Indonesia, Brazil, Turkey and South Africa.
Mr Dudley said the Fed is listening, but he also left no doubt that the US intends to press ahead with monetary tightening this year despite the risks, warning that underlying inflationary pressures in the American economy have been disguised by a one-off slump in oil prices. "My expectation is that inflation will begin to firm later this year," he said.
The Fed has concluded that the abrupt economic slowdown in the first quarter - with growth falling to 1.5pc from an average of 2.7pc over the past two years - was a temporary blip caused by freezing weather and port disruptions.
Mr Dudley said interest rates in the US should be around 3.5pc once inflation returns to 2pc.
While the comment was tucked away at end of his speech, it is a warning shot that should send shivers down a great many spines.
Borrowing in dollars outside the US has surged from $2 trillion to $9 trillion over the past 15 years. Half of this is now concentrated in emerging markets, including $630bn to Russian companies and state entities, and roughly $350bn to Brazilian firms.
It also includes at least $1.1 trillion of loans to Chinese companies, much of it through Hong Kong and intended to circumvent China's internal credit curbs. It is clear that many investors have been engaged in a currency "carry trade", betting - wrongly as it now turns out - that the dollar would weaken against the yuan. Others took advantage of cheap dollar credit during the era of quantitative easing to speculate on the Chinese property market.
Emerging market borrowers have been issuing dollar bonds at an average real rate of just 1pc.
The great worry is what will happen as increasingly large blocs of bonds or loans - typically on five-year maturities - come due for refinancing in a far less friendly world. The dollar has almost doubled against the Brazilian real and the Russian rouble since mid-2012.
The IMF warned in its global financial stability report that the world must prepare for the double stress test of a soaring dollar and a sudden jump of 100 basis points in 10-year Treasury yields.
“Shifts of this magnitude can generate negative shocks globally. Emerging market economies are particularly exposed: they could face a reversal in capital flows," it said.
It warned that markets have been beguiled by the lowest bond yields in history and "an illusion of liquidity", wrongly assuming that central banks will always come to the rescue. "A sudden shift in market views that unwinds compressed premiums and sends yields higher could trigger a market liquidity shock," it said.
Whatever the pieties of international solidarity, the Fed invariably acts in the US national interest when push comes to shove, and there are clear signs that the US is shaking off its deflationary woes and needs tighter money.
Mr Dudley said fiscal austerity is over. Household deleveraging has "largely run its course".
There is no longer an overhang of excess inventory in the housing market. He predicted that growth will soon pick up again, driving unemployment down to 5pc by the end of the year.
While wages have been sluggish, the number of hours worked is rising briskly, swelling pay packets at a rate of 4.7pc in the second half of last year. Sooner or later, this will flood into consumption.
"If financial market conditions do not tighten much in response to higher short-term interest rates, we might have to move more quickly to achieve the appropriate restraint on financial market conditions," he said.
Mr Dudley said some emerging markets - above all India, though he cited no names - have learned from the taper tantrum, taking steps to bolster their defences and push through reforms. But not all have done so.
The emerging world also has better central banks and financial regulation than during past episodes, and ought to be able to weather the storm.
However, Mr Dudley also hinted at a repeat of the Fed tightening cycle from 1994 onwards, a saga that led in turbulent phases to the East Asia crisis and Russia's default in 1998. The problem then was a "considerable gap" between what markets were expecting and the shock therapy that the Fed in fact delivered.
The parallels are becoming uncanny. Markets are pricing in Fed rates of just 0.9pc by the end of 2016. The Fed itself is signalling 1.875pc. One of them is badly wrong.
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