Tuesday, January 28, 2014

When Monetary Superpowers Flex, Emerging Market Investors Flee

A common theme on this blog has been that the Federal Reserve is a monetary superpower. Consequently, it has had an outsized role in shaping global liquidity conditions. Here is how I explained it before:
I have made the case many times that the Federal Reserve is a monetary superpower. The Fed has this power because it manages the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. As a result, its monetary policy gets exported to much of the emerging world. The ECB and Bank of Japan are also influenced by the Fed's decisions because they are careful not to let their currencies becomes too expensive relative to these dollar-pegged currencies and the dollar itself.  U.S. monetary policy, consequently, gets exported to the Eurozone and Japan as well.  

This understanding helps explains why there was a global liquidity glut during housing boom period and suggests that some of the "global saving glut" was simply a recycling of loose U.S. monetary policy.  It also implies that the Fed could now do a lot of good for both the U.S. and Eurozone economies if were to adopt something like a NGDP level target.  Based on this view, the global economy sorely needs the Fed to wake up from its slumber. Fed Chairman Ben Bernanke admitted as much in one of his classroom lectures earlier this year
Lars Christensen makes a compelling case that China also acts as a monetary superpower, at least for the emerging markets and commodity exporters. The actions, then, of both the Federal Reserve and the People's Bank of China (PBoC) matter immensely to the rest of the world. This seems especially true now as the expected tightening of monetary policy by these central banks is hitting emerging market hard. Ambrose Evans-Pritchard reports :

Turkey, India, Brazil and a string of emerging market countries are being forced to tighten monetary policy to halt capital flight despite crumbling growth, raising the risk of a vicious circle as debt problems mount.


The emerging market bloc makes up half the world economy, far higher than in any previous crisis. The International Monetary Fund warns that the sheer weight of these countries' rate raises could lead to a “blowback” effect that ultimately hits the US, Europe and Japan as well.
“The epicentre of the global financial storm had shifted to emerging markets from Europe, and this third phase of the global financial crisis is intensifying. We are still in the very early stages,” said Stephen Jen from SLJ Marcro Partners.


Simultaneous monetary tightening by China’s central bank and the US Federal Reserve has been the trigger for latest rout, so any sign that either Beijing or Washington is having second thoughts is an instant tonic for investors.

“We have all these countries in trouble like Argentina, Ukraine and Thailand that are each local cases, but behind the whole emerging market story is Fed tapering and worries about slowing Chinese growth,” said Lars Christensen from Danske Bank. “China is now a global monetary superpower, co-leader with the US. When China tightens, that hits trade and commodities across the world.” 
Even though the actions of the Federal Reserve and the PBoc may have been the catalyst to these latest worries, the emerging markets could have been better prepared for the inevitable tightening:
“Emerging economies squandered precious opportunities in the past decade to reform and restructure for the new globalised world. Instead, they rode on the coattails of China and ample global liquidity,” said Mr Jen, a former IMF firefighter.
Be that as it may, the interesting question going forward is how policymakers will respond. India and Brazil have already incrementally raised their policy interest rates. And today we learned that Turkey decided to one-up them by going the "shock and awe" route: it raised its interest rate target from 7.75% to 12.00%. I am all for utilizing the power of expectations, but this sharp rate hike could end badly. Will the Federal Reserve also respond to these developments? We find out tomorrow.

Addendum: The growing importance of the emerging markets to the world economy can be seen in the figure below.


  1. Very important and excellent blogging.
    It is quite a state of affairs when a non-independent communist central bank---the People's Bank of China---does a better job than the Fed.
    But who can deny it?
    How did China perform in the 2008 bust, vs. the USA?

    Something odd too: By assuming a too-tight monetary policy, the USA will somewhat suffocate its own economy, and become less relevant globally, while China, with a pro-growth monetary policy, will naturally become more and more influential.

  2. OT but maybe David B. will enjoy this.

    A while back I think David B. suggested that simply crediting taxpayer bank accounts with money created by the Fed was a good idea.

    I think something along these lines now happens with the Food Stamp program, where recipients just get a EBT card and they have money they can spend---on food only, but since everybody eats, this is like money.

    A long time ago these guys said Food Stamps add to the money supply:

    Food Stamps as Money and Income
    Daniel S. Hamermesh, James M. Johannes
    NBER Working Paper No. 1231
    Issued in November 1983
    NBER Program(s): LS
    Food Stamps represent nearly $11 billion of personal income in the United States. The coupons that are issued to represent the purchasing power available to recipients are also reserves for the commercial banking system.This study asks how closely these coupons are substitutable for what is usually considered as money, and how well Food Stamps function as a fiscal stabilizer (whether they increase consumption more than does ordinary income). The results, based on estimates for 1959-1981, suggest that Food Stamp coupons are perfectly substitutable for Ml, and a revised money-supply series including "Food Stamp Money" is included in an Appendix. Estimates of consumption functions indicate that the MPC out of income in the form of Food Stamps is higher than that out of ordinary income. Taken together, the results suggest that the Food Stamp program is an automatic fiscal and monetary stabilizer -- under its provisions, both the money stock and disposable income are increased during a recession.

    This may be the wrong time to cut the Food Stamp program, and so the Fed probably should step on the gas even harder....

    1. Thanks Benjamin for your reply. If one accepts your premise that PBoC has done better than the Fed, one also have to remember that PBoC has far more power to act than the Fed. All the internal debates in the Fed and the external pressure from Congress makes it far harder for the Fed to do what is needed.

    2. David--

      Maybe so...but would have the Fed adopting open-ended, results-dependent QE (QE3) at the get-go in 2008 faced much more resistance than the stop-and-go Fed QE policy (QE 1 and QE2)?

      I concur that the FOMC has become loose cannons on deck and with some anchors also (to use your boating analogy).

      But the FOMC is the Fed! We cannot say the Fed is doing a so-so job, but it is not the Fed it is is the FOMC.

  3. The FOMC’s 2013 monetary policy was, on balance, contractionary (i.e., QE didn't work). The current sell off in the financial markets was predicted as a result. It’s a reoccurring phenomenon., e.g. Mexico Peso crisis Dec 1994,, U.S. dollar/Yen fall (3%) in Mar. 1995, Asian financial crisis July 1997, Russian financial crisis Aug 1998, Brazilian peso crisis Jan 1999, Argentina crisis Dec 1999-2001, Japanese financial crisis 1991, etc.

    Some people think Feb 27, 2007 started across the ocean. "On Feb. 28, Bernanke told the House Budget Committee he could see no single factor that caused the market's pullback a day earlier". Virtually all of these re-arrangements occurred as our FED "tightened" monetary policy (i.e., they were due to monetary policy blunders).

  4. The July 2008 collapse of the E-D market (which triggered the Great-Recession), was an exception. The E-D market collapsed as the E-D's prudential reserves evaporated. The prudential reserves of the E-D banks consist of various U.S. dollar-denominated liquid assets (U.S. Treasury bills, U.S. commercial bank CDs, Repurchase Agreements, etc.) and interbank demand deposits held in U.S. banks. These are liquid balances in the U.S., or any other major currency country. If a bank’s balance is inadequate to meet a specific payment in the E-D system, it borrows in the London money market at or near the LIBOR rate (the London Inter-bank Offering Rate), a rate substantially below the prime rates of most banks.

  5. David,

    TravisV from TheMoneyIllusion comments section here.

    Could China’s aggressive easing-then-tightening of monetary policy explain gold’s dramatic rise (2009 to 2011) then fall (2012 to 2013)?

    Or has gold fallen because we’ve found so much new oil (increasing real interest rates and lowering the attractiveness of gold)?

    1. Travis, your first point seems plausible but I honestly don't know enough to be certain. I would like to hear more on your second point. Why would there be higher interest rates?

    2. Aside from gold's other supply & demand factors, the decline in the dollar's exchange rate & inflation expectations primarily determined the trend in gold. This trend was interrupted in July 2011, with the FDICs increased insurance coverage. Then this year, the roc in the proxy for inflation made a big downside move.

  6. I’ve done Granger causality tests on the US monetary base (i.e. QE) over the period since December 2008 and find that the monetary base Granger causes the real broad dollar index, the S&P 500, the DJIA, commercial bank loans and leases, the PCEPI, and 5-year inflation expectations as measured by TIPS. None of this should be terribly surprising from the standpoint of standard textbook monetary economics.

    I've also run such tests with respect to a variety of investment asset classes based on the claims of numerous financial analysts. I find that the monetary base Granger causes high-yield bonds, global equities, 3-month CD yields and 10-year T-Notes yields. The impulse response results show that QE significantly increases high-yield bonds (reduces yield), increases global equities, reduces 3-month CD yields and decreases 10-year T-Notes (increases yield).

    Of these, only the T-Note yield result is the opposite of what most financial analysts tell their clients, although this is entirely consistent with what standard textbook monetary economics predicts via term structure theory. The fact that US QE increases global equities is mostly attributable to the simple fact that US equities are a significant share of global equities.

    But there are lots (and lots) of things that the US monetary base does not Granger cause over the period since December 2008 that most financial analysts nevertheless insist QE has an effect on. In particular the monetary base does not Granger cause the price of gold, copper or crude oil, the Japanese Nikkei 225 index or emerging market equities.

    Thus all of the turmoil being experienced in the emerging markets right now very likely has very little to do with what the FOMC has been deciding to do in the confines of the Eccles Building in Washington DC.

  7. Mark, interesting results, but I disagree with your conclusion. You need to run granger causality tests on EM real exchange rates. And even then, I believe this link here is more on the expected path of Fed policy not its current monetary base level. So you would want to model that too.

    Here is why I think you need to look at real exchange rates. There is some anecdotal evidence QE2 played a part in China's real appreciation. QE2 meant the Chinese had to buy up more dollar assets to prevent its crawling peg from appreciation too fast. That response, however, meant more Chinese monetary base creation that in turn required either costly sterilization or higher inflation. We have seen some of the latter which has contributed to the real appreciation of China. Back when there was all this talk about currency wars and QE2, someone in the White House was alleged to have said that Bernanke accomplished with QE2 what we trying to do with threats of trade sanctions with China. This is kind of power I see the Fed having.

    Colin Grey has great thesis at Standford (under John Taylor's direction) where he systematically documents this superpower status. See this link: