Watch the Fed’s balance sheet, not interest rates

The US central bank’s unwinding has contributed to turmoil in emerging markets

Gillian Tett

Urjit Patel, the governor of India's central bank, warns that the turmoil in emerging markets could get worse as the Fed's balance sheet unwinds © Bloomberg

When the mighty US Federal Reserve started to unwind its bloated $4tn balance sheet last year, some investors braced themselves for a shock. But it did not immediately transpire — or at least not in a way that American cable television shows (or a president) might notice.

On the contrary, US markets seemed so impervious to the unwinding that many investors have almost forgotten that it is happening. Instead, the main, obsessive focus for debate around the Fed right now is whether it will raise policy rates three or four times this year.

But if Urjit Patel, the governor of India’s central bank, is correct, this obsession with US interest rates misses the point. Writing in the Financial Times earlier this week, Mr Patel argued that the Fed’s balance sheet unwinding is quietly contributing to the current turmoil in emerging markets. He warned this could soon get much worse.

This is not because Mr Patel thinks that the Fed was wrong to embark on the unwinding. Instead, he worries that President Donald Trump’s subsequent tax cuts have caused the US deficit to unexpectedly widen, sparking much higher-than-projected issuance of US debt. Indeed, some $2.34tn of treasuries will be sold in the next two years. 

Global investors will need dollars to buy those bonds. However, the rub is that the Fed’s unwinding is sucking dollars out of the system, currently at a pace of $20bn a month, which is slated to rise to $50bn next year (or a cumulative $1tn of liquidity by December 2019.) That creates a dollar liquidity squeeze, Mr Patel fears, and means that “a crisis in the rest of the dollar bond markets is inevitable”, with a growing “possibility . . . a ‘sudden stop’ for the global economic recovery”. So he wants the Fed to change course — by slowing that unwinding.

The Fed itself has not responded in public to this remarkable plea. But investors should take note on several counts. For one thing, central bank governors do not usually warn so bluntly about the risks of a looming financial shock. Nor do they usually shout so loudly about controversial fiscal issues — let alone in another country.

But Mr Patel is not the only non-American central bank governor or official who now has these concerns. On the contrary, similar sentiments have been privately tossed around at a number of international meetings in recent weeks, as the full impact of Mr Trump’s tax cuts have become clear.  

Will the Fed listen? Under the new leadership, that is unclear. Jay Powell, the new chairman, recently offered some intriguing hints about how he thinks the Fed should view its impact on non-US markets — at least in respect to US interest rates. Last month, he told a seminar organised by the IMF and Swiss National Bank that while cross-border “spillovers [from policy] are to be expected in a world of highly integrated financial markets”, the last decade of data suggested that the role of US monetary policy on global markets is “often exaggerated”. 

By way of proof, he noted that capital flows to emerging market economies slackened in 2011 when the Fed eased policy, but increased in 2013 when it tightened — even though logic might suggest that tighter US policy should suck capital from those economies. The Federal Reserve “played a relatively limited role in the surge of capital flows to EMEs”, he concluded.

This suggests that Mr Powell himself will have little sympathy if EMEs try to blame the Fed for any market turmoil, or ask it to change course. In any case, he, like other senior Fed officials, seems (justifiably) very keen to stay on the same path at this point, to ensure that the Fed has firepower when the next recession hits. 

But some Fed officials accept Mr Patel’s point that higher bond sales are changing the landscape. They also know that it will be much easier to modify the process of unwinding, if necessary, than tweaking high-profile rates since the Fed has huge discretion in this field. After all, most politicians (and White House officials) do not have the foggiest idea about the details of the balance sheet now.

The main conclusion for investors is that they should heed Mr Patel and recognise that interest rates are not the only game in town. They need to watch to see what the Fed does (or does not) do next with that balance sheet. And while Mr Patel is entirely correct to suggest that the Fed needs to take Mr Trump’s tax cuts into account, and consider tweaking policy, I would not bet many dollars (or rupees) that the Fed will ever publicly accept his plea. Investors in emerging market assets should be warned.

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