Emerging economies must prepare for US Fed policy tightening: IMF

By Gyanendra Kumar Keshri
New Delhi [India], January 10 : High inflation and COVID-19 new variant Omicron have made the outlook for emerging markets like India more uncertain. Another big challenge for the emerging economies would come from the policy rate hike from the United States Federal Reserve.
Faster rate increases by the Federal Reserve could "rattle financial markets and tighten financial conditions globally" and the emerging economies must prepare for it, the International Monetary Fund (IMF) said.
"Broad-based US wage inflation or sustained supply bottlenecks could boost prices more than anticipated and fuel expectations for more rapid inflation. Faster Fed rate increases in response could rattle financial markets and tighten financial conditions globally. These developments could come with a slowing of US demand and trade and may lead to capital outflows and currency depreciation in emerging markets," IMF said in a blog published on Monday.
The impact of Fed tightening in a scenario like that could be more severe for vulnerable countries.
In recent months, emerging markets with high public and private debt, foreign exchange exposures, and lower current-account balances saw already larger movements of their currencies relative to the US dollar. The combination of slower growth and elevated vulnerabilities could create adverse feedback loops for such economies, the IMF said.
The United States Federal Reserve last month indicated that it would soon increase policy rates.
According to minutes of the Federal Reserve's December 14-15, 2021 meeting released on January 5, 2022, the US central bank policy makers were of the view that a stronger economy and higher inflation could warrant interest rates hike "sooner or at a faster pace".
Addressing a news conference last month US Federal Reserve Chairman Jerome Powell said: "The economy no longer needs increasing amounts of policy support."
Low policy interest rates have helped stimulate US economic growth. However, the central bank is now likely to focus more on the threat posed by inflation.
The current policy interest rate in the United States stands at 0.1 per cent. Analysts believe that the US Fed could raise rates thrice in 2022. The first hike could be in March.
The hike in interest rates in the US would lead to pulling out money by the global funds from the Indian equities markets, bonds and the government securities. The overseas borrowings by the Indian firms would become costlier.
Pulling money out of the Indian markets by the foreign portfolio investment (FPI) could weaken the Indian rupee.
It would also force the Reserve Bank of India (RBI) to increase policy rates. Soon after the COVID-19 pandemic hit the world, the RBI reduced the policy repo rate to a historic low of 4 per cent in May 2020. The reverse repo rate was cut to 3.35 per cent. The RBI cut these rates to the record low in order to support the economy disrupted by badly by the COVID-19 pandemic.
The RBI not changed the key policy rates after May 2020. However, the Indian central bank is under increasing pressure to hike rates as inflation has increased sharply in the recent months.
The hike in policy rates by the US Federal Reserve would put increasing pressure on the RBI to hike rates.
In the blog post the IMF pointed out that "some emerging markets have already started to adjust monetary policy and are preparing to scale back fiscal support to address rising debt and inflation."
"In response to tighter funding conditions, emerging markets should tailor their response based on their circumstances and vulnerabilities," the IMF said.
Those with policy credibility on containing inflation can tighten monetary policy more gradually, while others with stronger inflation pressures or weaker institutions must act swiftly and comprehensively.
In either case, responses should include letting currencies depreciate and raising benchmark interest rates. If faced with disorderly conditions in foreign exchange markets, central banks with sufficient reserves can intervene provided this intervention does not substitute for warranted macroeconomic adjustment, it added.