I wrote in an article in June that we were in a world of heightened risk of policy error, and that policymakers would have to be much more agile and responsive as they waded into the fog. At the time, the US Federal Reserve (Fed) characterised inflation as transitory, and was reluctant to talk about tapering asset purchases, let alone hiking interest rates. The Fed was more worried about protecting growth, ignoring the shrill noise of those sounding the alarm about rising inflation risks.
Now tight labour markets and wage inflation suggest the risks to the inflation outlook in the US are high, and that inflation could be anything but transitory.
The Fed has since started tapering asset purchases and has signalled that rate hikes will start in March. The market is predicting that the federal funds rate will be hiked five times in 2022. In June, the prediction by the markets and the Fed governors was for one hike only. How the world has changed in seven months.
Just like its decision not to respond to early signs of inflation, the Fed’s decision to aggressively hike, should it pursue that avenue, carries its own set of risks. Simultaneous tightening of both fiscal and monetary policy, while understandable in the current context, risks too fast a loss of momentum for the US economy. If the Fed makes this error it will stall tightening at some point.
Then there is the potential effect of US monetary policy tightening on global growth momentum. In principle, the Fed only considers developments in the US economy when making policy decisions. However, because of the dollar is the global reserve currency its decisions affect the global costs of funding and financial flows.
In some ways the Fed is the de facto global central bank. It cannot ignore indefinitely what happens in the rest of the world because of its policy decisions. However, in the near term it can, and probably will.
Cheap funding
Which brings us to what is likely to be the core issue for emerging markets in this tightening cycle. In its October 2021 Fiscal Monitor the IMF showed that the progrowth fiscal policy response to the Covid-19 economic shock was very strong in advanced economies, anaemic in emerging markets and almost nonexistent in low-income economies. advanced economy GDPs are thus expected to be back at prepandemic levels by 2024. In contrast, emerging market and low-income developing country economy GDPs are not expected to recover to prepandemic levels over the fund’s forecast horizon.
The key difference between emerging and developed market economies during the crisis was access to affordable debt. Developed economies were able to get cheap funding and run war-level deficits to support their economies and people as the economic crisis unfolded. Developed market debt-to-GDPs jumped by just less than 20 percentage points in 2020. Emerging markets raised debt by about 7% of GDP, and low-income countries by just 4%.
The reasons for this differential in access to debt are historic and complicated. However, this experience of variability in access to money, like the variability in access to vaccines, will come to haunt the global political economy.
Many emerging markets, whose economies remain in a postcrisis slump, must now raise rates because developed market central banks are tightening. This will only worsen the economic outcomes for these countries and further erode welfare for their people. SA is one of the economies subject to this dynamic. The Reserve Bank is hiking during the worst economic and jobs crisis post-1994.
The IMF continues to raise the alarm and warn of a rising risk of debt distress in emerging market and low-income countries. The economic hangover from the Covid-19 crisis could yet endure, and this will eventually prove a drag for developed economies too. Failure to address fragilities and inequalities at a global level could be the biggest policy mistake of all.
• Lijane works in fixed income sales and strategy at Absa Corporate & Investment Banking.
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