News in Charts: The perils of tighter Fed policy

With the US economy back above its pre-crisis level of output and with inflation overshooting the Federal Reserve’s target, investors are shifting their focus towards the outlook for monetary policy. Speaking on 3 March, Jerome Powell, the chair of the Fed, confirmed plans to raise rates in March as inflation remains persistently high. Fathom expects the FOMC to announce a 25-basis point hike, although the risk to this is to the upside with markets last month pricing in a more than 90% likelihood of a 50-basis point hike. More hikes are expected this year. The prospect of US monetary tightening raises concerns over a rerun of 2013’s ‘taper tantrum’ which caused a sell-off in EM assets.

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Historically, EM central banks have tended to tighten monetary policy in line with the Federal Reserve, with a view to protecting the value of their currencies. While many are now following this policy prescription and hiking their policy rates in anticipation, this is not true everywhere. European and South American central bankers (including many commodity exporters) have opted for pre-emptive tightening, while their counterparts in Asia have been more cautious, potentially leaving their currencies vulnerable. Turkey is notable for its unconventional monetary policy by announcing significant policy easing, even in the face of an elevated inflation rate.

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Currency depreciations are rising but remain less severe than during the 2013 taper tantrum, with outcomes not visibly correlated with changes in central bank policy rates, although the Russian invasion of Ukraine has generated a handful of exceptions. The possibility that depreciations will worsen in the future cannot however be ruled out. It is worth noting that Currency FVI scores are forecast to rise sharply in the coming quarters, much as they did during the taper tantrum.

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Ordinarily, the best predictor of an imminent currency crisis is the size of a country’s current account deficit. This held true even during the pandemic — of the 20 countries experiencing the largest depreciations since the start of 2020, seven possessed large deficits in the build-up. More notably however, most of the top 20 are commodity exporters. Sharp falls in the prices of many commodities during the pandemic have been reflected in a reduction in the value of the group’s exports, and consequently in demand for their currencies. For the countries within this group that are not commodity exporters, the declines in the value of their currencies appear largely idiosyncratic in nature, driven by either institutional or political factors.

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Of course, the COVID recession was ultimately short-lived, and V-shaped in nature. As a result, the commodity price effect may soon reverse, and demand for the net exporters’ currencies increase. Moreover, commodity importers may find that higher prices lead to a deterioration in their own current account balances, amplifying the vulnerability of those with already-large deficits. Several countries — including Cambodia, Dominica, Guyana, Lebanon, Liberia, the Seychelles and the Central African Republic — look vulnerable on this basis.

Monetary tightening by the Fed does not solely affect currency risk; it raises borrowing costs for EMs and as such will also increase the likelihood of sovereign crises. Indeed, we already find signs that the Sovereign FVI is tracking the uptick in the Currency FVI. It is not surprising to find links between the two crisis types, since it is often the case that countries with large fiscal deficits also possess large current account deficits — the so-called ‘twin deficit’ phenomenon.

From the perspective of national accounts, there are essentially two ways a government can finance an increase in its budget deficit — it can either borrow domestically, implying either an increase in private savings or a fall in investment, or it can borrow from abroad, implying an increase in the capital account surplus/current account deficit.

Thus, given that the twin balances will often tend to co-move, and that each balance plays a large part in explaining the likelihood of each crisis type, it is unsurprising to find that currency and sovereign crises often occur simultaneously. Around one third of sovereign crises occur within one  year of a currency crisis, and it is for this reason that there is a substantial degree of overlap between the drivers of Fathom’s two FVI models.

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