This Week in Monetary Policy

Ben Bernanke chaired his last Fed meeting this week, and if you believe the headlines, he ended his tenure on a bizarre note: blowing a raspberry at Emerging Markets. At least, that was the broader takeaway after the Fed voted to reduce quantitative easing (QE) bond purchases by another $10 billion per month, just days after three developing nations hiked rates to (allegedly) combat currency drops (allegedly) caused by the first QE trim. In our view, though, the notion of the Fed bearing responsibility for—and thumbing its nose at—Emerging Markets volatility is misplaced. One, the Fed isn’t the world’s great stabilizer. Two, US monetary policy doesn’t appear to be the culprit for recent currency woes in Argentina, Turkey and South Africa. Volatility might continue as jitters persist in the near term, but in the long run, we still view slowing QE bond purchases as an incremental positive for global markets.

The saga began last week when the aforementioned countries and Russia experienced significant currency declines. As wewrote, this stemmed from localized issues—independent of the Fed. But most headlines saw this otherwise, claiming currencies tanked because QE tapering was driving capital out of Emerging Markets currencies and bonds, in search of the now more attractive higher yields stateside—and all developing nations were at risk. This drove jitters throughout Emerging Markets, causing even the healthiest to see some currency volatility. As the slide escalated this week, some central banks took action. India was the first to act, hiking its repo rate by 25 bps to 8%. Some observers pointed to the rupee’s recent weakness, but Reserve Bank of India (RBI) Governor Raghuram Rajan made it clear his target was India’s 10% inflation rate—a move telegraphed in policy proposals released last week, which Rajan said factored heavily in his decision. In a later conference call, Rajan said point blank his decision had nothing to do with the Fed—a refreshing change from last summer, when his predecessor seemingly reacted to QE ghost stories about by hiking India’s other overnight rate, the bank rate, two times—and inverting the yield curve in the process. This time, India’s yield curve, though flattish, remains positively sloped.

South Africa acted Wednesday, hiking its key interest rate by 50 bps to 5.5%. The move was a surprise—most expected rates to hold till May. But with the rand among Emerging Markets’ fastest-falling currencies, central bank Governor Gill Marcus and her deputies felt compelled to intervene. Yet while her statement implied Fed policy factored into the decision, the rand has been on steady decline since early 2011—right around the time metals prices peaked. South Africa’s economy depends heavily on metals and mining, which have been hampered by a supply glut. Overall and on average, as prices go, so goes the South African economy and the rand.

Turkey had the biggest currency slide—and announced the biggest rate hike. Policymakers bumped the overnight lending rate from 7.75% to 12% and the borrowing rate from 3.5% to 8%, and they switched the main policy rate to the one-week benchmark repo rate and hiked it from 4.5% to 10%. The move is big, but not unexpected. Rates were artificially low, largely to appease Prime Minister Recep Tayyip Erdogan’s staunch public opposition to rate hikes. Now, judging from the lira’s subsequent stabilization, they’re more credible. Credibility is the key here—the Fed gets the blame for Turkey’s currency woes, but the combination of political instability and the resulting bizarre monetary policy (including temporary rate hikes on “special” days) bear most of the blame for scaring off capital.

In short, it was three central banks responding to three sets of localized issues. But many didn’t see it that way! They saw three central banks backed into a corner by Fed policy, forced to hike rates and handicap future growth prospects in the process (a fallacy—rate hikes aren’t inherently bad for economies). According to this interpretation, common sense and courtesy should have led the Fed to pause its QE winddown, for the sake of Emerging Markets and (potentially) global stability. So they were miffed when Bernanke and Company tapered again, citing continued signs of economic strength in the US and not saying a word about the past week’s volatility.

But last we checked, the Fed’s primary job is to be lender of last resort for domestic banks and manage the money supply (and, lately, regulate banks). Central banks globally do occasionally work in concert with each other, as the Fed did by helping the ECB establish dollar swap lines during the worst of the eurozone crisis, but that’s light years away from allowing currency moves in some developing markets to impact domestic monetary policy moves. Moreover, there was no fundamental need for the Fed to let Emerging Markets volatility impact its decision—QE isn’t and hasn’t been a fundamental driver of developing-world economies and asset prices, and its end won’t cause a “contagion” that threatens the US economy. In our view, staying cool and refusing to react to the noise—and moving closer to the end of a policy that weighed down growth—is the most economically beneficial move.

Not just beneficial for the US, but the entire world—Emerging Markets included. QE didn’t drive “hot money” into Emerging Markets, but when bond buying pulled down US long-term rates, it pulled down long-term rates globally, shrinking yield curve spreads. When QE ends, long-term rates rise, and spreads should widen globally, giving the global economy more fuel. And with most observers still seeing this issue backward, the stage is set for positive surprises to push stocks higher over time.