The Coming US Interest Rate Tightening Cycle: Smooth Sailing or Stormy Waters?

Abstract

The U.S. Federal Reserve (Fed) is expected to start raising policy interest rates in the near term and thus commence a tightening cycle for the first time in nearly a decade. The taper tantrum episode of May-June 2013 is a reminder that even a long anticipated change in Fed policies can trigger substantial financial market volatility in Emerging and Frontier Market Economies (EFEs). This paper provides a comprehensive analysis of the potential implications of the Fed tightening cycle for EFEs. We report three major findings: First, since the tightening cycle will take place in the context of a robust U.S. economy, it could be associated with positive real spillovers to EFEs. Second, while the tightening cycle is expected to proceed smoothly, there are risks of a disorderly adjustment of market expectations. The sudden realization of these risks could lead to a significant decline in EFE capital flows. For example, a 100 basis point jump in U.S. long-term yields could temporarily reduce aggregate capital flows to EFEs by up to 2.2 percentage point of their combined GDP. Third, in anticipation of the risks surrounding the tightening cycle, EFEs should prioritize monetary and fiscal policies that reduce vulnerabilities and implement structural policy measures that improve growth prospects.

Keywords: Federal Reserve, liftoff, tightening, interest rates, monetary policy, emerging markets, frontier markets, capital flows, sudden stops, crises

JEL Classification: E52, E58, F30, F65, G15