Confused Fed adds to emerging market muddle

March 20, 2014

By Andy Mukherjee

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

A confused U.S. Federal Reserve has added to the muddle in emerging markets.

At their meeting that ended on March 19, the nine voting members of the Federal Open Market Committee (FOMC) wriggled out of a previous commitment to start increasing interest rates after unemployment had fallen to 6.5 percent. To assure markets that overnight rates will stay at near-zero levels, the committee promised instead to seek maximum employment and 2 percent inflation.

The accompanying Economic Projections document, though, poured cold water on this dovish, if somewhat vague, statement. In it, FOMC members – both voting and non-voting – bumped up their expectation of future interest rates. The committee’s median expectation for the target overnight rate at the end of 2016 is now 2.25 percent, up half a percentage point from its previous estimate, according to Barclays. The hawkish projections caused a selloff in U.S. Treasury bonds. Asian equities and currencies followed suit.

The mixed message raises concerns of another Fed communication failure. Last summer, the Fed had a tough time persuading investors it could gradually reverse quantitative easing without accelerating its first rate increase. The subsequent “taper tantrum” cut many emerging market countries’ access to dollar funding.

If investors once again start to doubt the U.S. central bank’s commitment to allow inflation to reach 2 percent before it raises rates, there will be a fresh bout of fund-raising pain for countries like Brazil, India and Indonesia whose current accounts are in deficit. Heightened uncertainty about the timing of U.S. rate increases could also make global markets more volatile, further slowing down investment.

Moreover, developed nations are facing bigger worries than they were last year. Signs of credit stress and an economic slowdown in China are growing, as shown by the weakening renminbi. The diplomatic standoff in Ukraine is a further headache. The Fed’s policymakers, who are as much in the dark as anybody else about how soon dormant inflationary pressures will re-emerge, are lighting a match to see where they want to take interest rates in 2016. That’s not a smart idea when investors are facing a mounting haystack of risks.

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