Global Economic Prospects 2015

The global economy is still struggling to gain momentum. Read more ...

Development Prospects

Providing information, analysis, and advice on global trends in the world economy.  Find out more ...

Global Economic Monitor

Now free. Daily and monthly updates on global economic developments and relevant topical issues. Find out more ...

Syndicate content

Fed taper announces new era for developing countries

Marc Stocker's picture

The dreaded moment has arrived. The US Federal Reserve announced on December 18 that it will begin a gradual tapering of its asset purchase program starting in January 2014, initially reducing it from $85bn to $75bn per month.

How did financial markets react to the news?

 Not much really. The muted response to-date largely reflects the “upsides” of the Fed policy announcement. In particular, investors are taking comfort in the upbeat assessment of the outlook for the US economy and the reinforced commitment to keep short-term policy rates unchanged “well past the time that the unemployment rate declines below 6-1/2 percent”, which by the Fed’s own forecasts will not happen until the end of 2015. This commitment (forward guidance) provides an important anchor for interest-rate expectations, and therefore reduces the risk that abrupt increases in long term yields might accompany the actual tapering of QE.
The Fed communication was a success and the initial reaction of markets reassuring, but this does not mean that developing countries are in the clear. Stock-markets and currencies in selected developing countries had already come under renewed pressure in recent weeks, reflecting anticipation of the approaching tapering announcement (see Figure 1). The absence of further reaction on the actual decision is more a vote of confidence for the Fed strategy than an assessment of longer term effects.

So what’s next?

Rising long-term interest rates, a stronger US dollar and greater volatility? No one can predict how well or how fast bond and foreign exchange markets will adjust to slowing demand for US treasuries coming from the Fed as of January, but given the dominant role that the central bank has come to play in long-term US sovereign debt markets (the Fed currently holds more than 50 percent of outstanding Treasuries of 8 to 10 year maturity, see Figure 2) a bumpy road ahead could be expected. As the Fed gradually pulls back from direct bond market interventions throughout 2014, any incoming data contradicting the current benign economic environment may be met with abrupt changes in expectations and disorderly rises in bond yields. This would have important ramifications for global portfolio decisions, with developing-country assets being particularly exposed to higher interest rates and greater risk aversion.   

It will take months to be able to assess the impact of the Fed decision for developing countries, but policy-makers should continue to anticipate and prepare for potential headwinds.
The turmoil in financial markets during the summer stands as a stark reminder that abrupt changes in US treasury yields can have significant impacts for capital flows, growth prospects and financial stability in developing countries, with effects being concentrated among those more financially integrated and with the largest vulnerabilities.
The recovery is consolidating in most developing regions and pre-emptive policies were undertaken in a number of countries to reduce their exposure, but assuming smooth adjustments ahead might be a bit premature.


Add new comment