The Coming US Interest Rate Tightening Cycle: Smooth Sailing or Stormy Waters?

Carlos Arteta

World Bank, Development Prospects Group

M. Ayhan Kose

Development Prospects Group at the World Bank

Franziska Ohnsorge

World Bank

Marc Stocker

World Bank

October 1, 2015

CAMA Working Paper No. 37/2015


The U.S. Federal Reserve (Fed) is expected to start raising policy interest rates in the near term and thus commence a tightening cycle for the first time in nearly a decade. The taper tantrum episode of May-June 2013 is a reminder that even a long anticipated change in Fed policies can trigger substantial financial market volatility in Emerging and Frontier Market Economies (EFEs). This paper provides a comprehensive analysis of the potential implications of the Fed tightening cycle for EFEs. We report three major findings: First, since the tightening cycle will take place in the context of a robust U.S. economy, it could be associated with positive real spillovers to EFEs. Second, while the tightening cycle is expected to proceed smoothly, there are risks of a disorderly adjustment of market expectations. The sudden realization of these risks could lead to a significant decline in EFE capital flows. For example, a 100 basis point jump in U.S. long-term yields could temporarily reduce aggregate capital flows to EFEs by up to 2.2 percentage point of their combined GDP. Third, in anticipation of the risks surrounding the tightening cycle, EFEs should prioritize monetary and fiscal policies that reduce vulnerabilities and implement structural policy measures that improve growth prospects.

The Coming US Interest Rates Tightening Cycle: Smooth Sailing Or Stormy Waters? – Executive Summary

Context: a longanticipated event, but still with substantial risks. Since the global financial crisis, the exceptionally accommodative monetary policy stance of the U.S. Federal Reserve (Fed) has helped support activity, bolstered asset valuations, and reduced risk premia. In addition, it has been instrumental in boosting capital flows to emerging and frontier market economies (EFEs). As the U.S. economy improves, the Fed is expected to start raising policy interest rates in the near term (an event widely referred to as “liftoff”) and thus commence a tightening cycle for the first time in nearly a decade. The mid-2013 “taper tantrum” episode is a painful reminder that even a long-anticipated change in Fed policies can surprise markets in its specifics, and lead to significant financial market volatility and disruptive movements in capital flows to EFEs. Recent debates have focused on the potential impact of the liftoff on EFEs, but there are also significant risks associated with the pace of subsequent rate increases, which is currently expected to be very gradual, but could accelerate at a time when EFE policy buffers are eroding.

This paper presents a comprehensive analysis of the changes in global conditions since the taper tantrum, risks of disruptions during the upcoming Fed tightening cycle, potential implications for EFEs, and policy options. Specifically, it addresses the following questions:

  • How have growth prospects and policies in advanced countries changed since the taper tantrum?
  • How have growth prospects and vulnerabilities in EFEs changed since the taper tantrum?
  • What are the major risks associated with the tightening cycle for EFEs?
  • What policy options are available for EFEs to cope with the potentially adverse effects of the tightening cycle?

Gradual healing in advanced economies. Activity in the United States continues to pick up, and labor markets are strengthening. While the recovery remains fragile in other major advanced economies, it has gradually firmed since 2013 (Figure 1). Despite the recent volatility, global long-term interest rates remain low, and the European Central Bank and the Bank of Japan are continuing to employ exceptionally accommodative monetary policies.

Growing vulnerabilities in EFEs. Since the taper tantrum, EFE growth prospects and credit worthiness have deteriorated, while vulnerabilities have risen in many countries (Figure 1).

Domestic vulnerabilities. Activity has slowed in many EFEs, and growth in 2015 is expected to be the weakest since the financial crisis. On average, private debt has increased and fiscal positions have generally deteriorated.

External vulnerabilities. Current account balances among several oil importing countries have improved somewhat but they have deteriorated among many oil exporters. EFEs with high levels of total external debt or with a large share of short-term external debt have made only limited progress in reducing such vulnerabilities. Foreign currency exposures remain elevated in some EFEs. Corporate debt has increased notably in several countries, with a significant share denominated in dollars.

Baseline: a smooth tightening cycle. There are multiple reasons to expect a smooth tightening cycle with only modest impact on EFEs:

  • The tightening cycle has long been anticipated and will most likely proceed very gradually.
  • It will take place in the context of a robust U.S. economy, which, according to a vector autoregression analysis, will have positive real spillovers to EFEs.
  • The term spread in the United States is likely to remain narrow as happened during some of the past tightening episodes.
  • Other major central banks are expected to continue pursuing exceptionally accommodative policies that would shore up global liquidity and help keep global interest rates low.

Significant risks around the baseline. The tightening cycle carries significant risks. Five factors heighten the risk of volatility in financial markets with adverse implications for activity in EFEs:

  • Uncertainty about the underlying strength of the U.S. economy creates ambiguity about how far the Fed actually is from achieving its dual objectives.
  • U.S. term premia are well below their historical average and could correct abruptly.
  • Market expectations of future interest rates are below those of the U.S. Federal Open Market Committee.
  • Market liquidity conditions are fragile.
  • An increasingly challenging external environment is eroding EFE resilience: global growth is soft, world trade growth is subdued, and commodity prices remain low.

Risk of a large decline in capital flows. Movements in U.S. yields play a significant role in driving fluctuations in capital flows to EFEs. If the tightening cycle were accompanied by a surge in U.S. long-term yields, as happened during the taper tantrum, the reduction in capital flows to EFEs could be substantial (Figure 2). According to a vector autoregression model, a 100 basis point jump in U.S. long-term yields (as occurred during the taper tantrum) could temporarily reduce aggregate capital flows to EFEs by up to 2.2 percentage point of their combined GDP. Such a large drop in capital flows could create significant policy challenges for vulnerable EFEs.

A perfect storm? Financial stress in global markets tends to disproportionately affect those EFEs that have weak growth prospects, sizable vulnerabilities, and challenging policy environments. Financial market volatility during the tightening cycle could potentially combine with domestic fragilities into a perfect storm that could lead to a sharp reduction in capital flows to more vulnerable countries. Over time, this risk could intensify as modest growth prospects become entrenched and vulnerabilities widen in some major EFEs. Furthermore, an abrupt change in risk appetite for EFE assets could lead to contagion affecting capital flows to many countries, even if they have limited vulnerabilities. This could turn a manageable slowdown in capital inflows to EFEs __________into an episode of multiple sudden stops, with significant adverse implications for growth and financial stability. An event study exercise suggests that growth in EFEs declines, on average, almost 7 percentage points in the two years following

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