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Fed bolsters view that US will drive global growth

September 19, 2013

WASHINGTON (AP) — The Federal Reserve’s decision to keep up its stimulus program bolstered the view that a strengthening U.S. economy will drive world growth forward in the coming months.

The Fed’s decision Wednesday to hold back on cutting its purchases of $85 billion a month in bonds may give a temporary respite to developing country economies, which were roiled by the prospect of a reduction. But the easing is inevitable and analysts see more pain ahead for the emerging markets.

The Fed had been widely expected to begin reducing the extraordinary bond purchases that have poured cash into the economy and supported growth at a time when already low interest rates could not be cut much further, limiting the Fed’s range of monetary policy options to spur sluggish growth.

But the central bank surprised by holding off to ensure that the U.S. economy is on a firm enough footing to withstand a pullback.

The ongoing stimulus bodes well for the strength of the U.S. economy but the Fed wants to start unwinding the unconventional stimulus measures and return to normal monetary policy. Central bankers also worry that if they do not begin cutting back, cheap and plentiful money could fuel inflation and bubbles in asset markets such as stocks or housing.

Earlier this month, the International Monetary Fund said it saw the dynamics of global growth shifting, with the U.S. expected to drive expansion in the near term helped by European and Japanese economies recovering from their slump. The forecast was a departure from IMF assessments earlier this year that developing economies such as China, India and Brazil would be the drivers of the global economy this year.

Those emerging economies have been rocked the past few months as anticipation grew for the Fed to begin easing off stimulus. While U.S. interest rates were low and cash was abundant, capital flowed into riskier emerging markets where rates were higher, making investments more lucrative.

The Fed’s warnings since May about the impending pullback in bond buying caused a big shift in those financial flows, sending some of that money back into the lower-risk U.S. market as interest rates rise again and growth prospects improve.

Some developing countries have seen their currencies and stock prices tumble as a result of that shift. In Asia, Indonesia and India have been the hardest hit because of weaknesses in their economies such as high inflation and current account deficits. India’s national currency lost a sixth of its value in recent months and stocks plunged.

The IMF has warned there is a risk of a crisis in emerging markets if that turmoil grows.

Win Thin, global head of emerging markets strategy at wealth management firm Brown Brothers Harriman, said there are disagreements within the Fed and enough uncertainty about the direction of monetary policy to keep emerging markets under pressure into next year. He also said he did not think the reversal of capital flows had run its course yet and it would take a while to completely play out.

“The rebalance is not finished yet,” he said. “From now until next year, it’s going to be pretty dicey for emerging markets.”

He said India, Indonesia, Brazil, Turkey and South Africa have the weakest economic fundamentals and as a result, have been performing the worst lately. He predicted that would continue to be the case, with their currencies and asset prices coming under pressure.

Joseph Gagnon, a senior fellow at the think tank Peterson Institute for International Economics, said he does not think the upheaval in emerging markets is really about the Fed tapering stimulus.

“I think that’s a total red herring,” said Gagnon, a former Fed and Treasury official. “The movement in emerging markets has nothing to do with tapering. Their growth is slowing down partly because they haven’t done reforms to make their economies more efficient. A lot of them haven’t conquered inflation, big budget deficits and inefficient subsidies such as energy subsidies. These are problems they haven’t solved and investors are seeing that and pulling money out,” he added.

The IMF is forecasting global economic growth will rise modestly in 2014 compared with this year. But the slowdown in emerging markets could mean a prolonged period of sluggish expansion in the world’s economy.

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