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Yellen’s Wishful Thinking

Tuesday, February 18, 2014

The new head of the Federal Reserve is imprudently dismissive of concerns about recent international economic developments.

Last week, in her congressional debut as head of the Federal Reserve, Janet Yellen paid short shrift to the notion that recent international economic developments should be a major concern to the Fed as it continues tapering its bond-buying program. By so doing, she risked repeating the mistake of Ben Bernanke, her predecessor, who at the start of his tenure in 2006 grossly underestimated the global economic impact of the imminent bursting of the U.S. housing bubble.

On the contrary, developments abroad are signaling that the international economy could constitute a major headwind to the U.S. economic recovery this year. After all, the emerging market economies presently account for more than half of the global economy. Yellen seems to have overlooked the fact that, in addition to the present crisis in a number of major emerging market economies, Chinese growth is showing clear signs of slowing, and disturbing economic and political developments are evident in Europe’s troubled periphery.

This confluence of difficulties across a wide swathe of the global economy should give Yellen pause.

If U.S. long-term interest rates increase by 1 percentage point as a result of Fed tapering, capital flows to emerging markets could be reversed by as much as 50 percent, according to a World Bank study.

Since May 2013, when Bernanke first floated the idea about Fed tapering, a number of key emerging market economies have come under severe pressure. This occurred as the earlier massive capital flows to these countries began to be reversed and as markets focused attention on those countries’ large domestic and external imbalances. This pressure has been reflected in a 10 to 20 percent currency weakening in Brazil, India, Indonesia, South Africa, and Turkey over the past nine months. In response to this weakening, these countries, which Wall Street refers to as the Fragile Five, have all begun to hike interest rates in an effort to curb the inflationary impact of currency weakening.

The Fragile Five’s immediate economic growth outlook does not appear promising. According to a World Bank study, if U.S. long-term interest rates increase by 1 percentage point as a result of Fed tapering, capital flows to the emerging markets could be reversed by as much as 50 percent. Further clouding the Fragile Five’s outlook in the next few months are contentious presidential and parliamentary elections. Those elections make it politically difficult for those countries to adopt the right economic policies to assure markets that domestic inflation will not be allowed to get out of control as capital flows continue to be reversed.

Yet another factor harming emerging market prospects is the economic outlook in China, the world’s second-largest economy and the principal driver of international commodity prices. The jury remains out as to whether the Chinese government will succeed in engineering a soft economic landing to the strong domestic credit boom that the country experienced over the past several years. However, even in the event of a soft landing, most analysts expect that Chinese economic growth will slow down to between 7 and 8 percent over the next year. Such a slowing would constitute a much less favorable environment for the emerging markets than that to which they have been accustomed.

Most analysts expect that Chinese economic growth will slow down to between 7 and 8 percent over the next year.

These emerging market economies’ difficulties are not in isolation. They coincide with Europe’s anemic economic recovery, which is showing clear signs of faltering, while the specter of deflation haunts much of Europe’s troubled economic periphery. In addition, it would seem that the political fragmentation that has characterized the Eurozone over the past few years shows no signs of abating, which must only complicate European economic governance. Indeed, the Italian government is about to change yet again, the Greek government is holding on to power by its finger nails, and European parliamentary elections scheduled for May 2014 are likely to register a strong anti-Europe protest vote across most of the continent.

Hopefully, these apparent risks to the international economy will not materialize. However, it is imprudent of Yellen to premise Fed policy on wishful thinking. Rather, she would seem to have been well advised to have alerted Congress to these risks. This would have made it easier for her to reverse course on tapering down the road, if international developments so require.

Desmond Lachman is a resident fellow at the American Enterprise Institute.

FURTHER READING: Lachman also writes "Europe's Outlook in 2014,""Why Greece Will Leave the Euro," and "Europe's Deflation Challenge." Alex J. Pollock contributes "The Federal Reserve's Second 100 Years." Tino Sanandaji explores  "The American Left’s Two Europes Problem."

Image by Dianna Ingram / Bergman Group

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