The Fed ignores emerging markets at its peril

The Federal Reserve’s track record in anticipating events that might seriously impact the U.S. economy is hardly stellar. For example, in 1994 it failed to predict the Mexican peso crisis, while in 1997 it was blindsided by the Asian currency crisis. More egregiously yet, in 2007, the Fed totally failed to anticipate the damage that the sub-prime lending crisis would wreak on both the U.S. and the global financial systems.

Today, at a time of increased emerging market turbulence, the Fed seems to be blithely oblivious to the risks that those developments might pose to the U.S. economy. Indeed, in last week’s FOMC policy statement, there was not as much as a mention of the emerging market currency crisis. There was no mention despite the many reasons to believe that troubles in the increasingly important emerging market economies could have a significant bearing on the U.S. economy.

{mosads}What makes the Fed’s seeming unconcern about the emerging market currency crisis all the more surprising is that there is every indication that this crisis will not be a fleeting phenomenon. As if to underline this point, on the very day of the FOMC’s meeting, significant interest rate hikes in India, South Africa, and Turkey, failed to restore confidence in emerging market currencies. Indeed, since then, the emerging market currency crisis has spread to emerging Europe where the Hungarian forint, the Polish zloty, and the Russian ruble are all now coming under considerable market pressure.

A further reason for thinking that the emerging market currency crisis could continue in the months ahead is the unfortunate electoral cycle that those countries face. Important parliamentary and presidential elections are scheduled in 2014 for Brazil, India, Indonesia, South Africa, and Turkey. In addition to heightening investor uncertainty, those elections are likely to preclude those countries’ governments from taking the unpopular measures needed to correct economic imbalances and to support the central banks’ efforts to stabilize their currencies.

It would seem that there are a number of reasons why the Fed ignores the emerging market currency crisis at its peril. First, emerging markets today account for an increased share of the global economy. While in 2000 emerging markets accounted for around 40 percent of the global economy, today as a result of very rapid emerging market economic growth they account for around 55 percent. As such, any marked slowing in these economies is bound have a direct bearing on the US economic outlook by diminishing US export prospects.

Second, continued turbulence in the emerging markets must be expected to have a negative impact on global financial markets and on risk appetite. As investors become more uncertain about the global economic outlook, they tend to sell equities and to move out of higher risk lending products. By so doing, they undermine the very channel of more buoyant asset market prices, on which the Fed’s quantitative easing policies so heavily relied.

Third, it would seem to be only a matter of time before the emerging market turbulence draws market attention once again to the very poor economic and political fundamentals in the European economic periphery. This would seem to be particularly the case considering that European politics is already heating up ahead of the May 2014 European parliamentary elections. And, if Europe were indeed again to come into play, one would think that even the Fed would become alert to the international risks to the US economic recovery that are now staring it in the face.

Sadly, even were the Federal Reserve now to become alert to the emerging market risk threatening the U.S. economic recovery, it would be difficult for it again to make a quick about-turn in its tapering policy. Such an about-turn would raise very important communication issues for the Fed, especially after its earlier mishandling of the tapering issue. It would also be very difficult for Janet Yellen at her first meeting as Fed chairperson to take the Fed on a different path than that set by Ben Bernanke, her predecessor. This makes it all too likely that the Fed will be late in backing off its tapering path, which only heightens the risk that the emerging market currency crisis will not dissipate anytime soon.

Lachman is a resident fellow at the American Enterprise Institute.