How candid should Janet Yellen be? Watching emerging markets overreact to Fed transparency

Perched before rows of reporters and thousands of traders watching on TV, Fed Chair Janet Yellen held her first press conference this time last week. It was hardly blockbuster television. Fed events never are.

But they’re a bigger draw than they used to be. Investors worldwide watched carefully to see what Yellen would reveal about the economic indicators the Fed’s Open Market Committee would use to set future policy — so called “forward guidance.” Fed-watchers expected some degree of transparency, in large part because of the communications strategy overhaul Yellen led under Ben Bernanke’s tenure as chair.

Before Yellen’s ascendance, of course, economists, reporters, academics, policy-writers, politicians, financiers, analysts and anyone else who cares about monetary policy (we’ll call them Fed-watchers) have been tuning in to the Fed each time Bernanke so much as sneezed.

Recently, they have all wanted to know one thing: when would the Fed start tapering. “Tapering” — a simple word that provokes blank stares from even the most astute news junkies — means exactly what it sounds like: a drawing down, or gradual reduction, in this case, of the Fed’s monetary stimulus, as we illustrated only recently on the NewsHour.

Since the financial crisis began in 2008, the Federal Reserve has sopped up several trillion dollars worth of mortgage-backed securities and Treasury bonds with newly created money, a process known as quantitative easing: “QE.” The last round has been doing so to the tune of $85 billion a month.

At their last meeting of 2013, the Open Market Committee decided to begin tapering these asset purchases by $10 billion a month. Last week, at the end of their two-day meeting, the committee approved another $10 billion reduction — bringing monthly bond purchases to $55 billion a month.

But even just hints at Bernanke’s June press conference that tapering was imminent sent Wall Street into a tizzy, beginning a short-term trend in which lower monthly unemployment numbers actually sent the market down because investors feared the Fed was closing in on its tapering threshold.

The big change is that Fed-watchers anxiously waiting for hints of tapering weren’t only to be found on Wall Street. Across the globe, in Mumbai, Istanbul, Makati City and elsewhere, financial markets were glued to that June Bernanke press conference. As they have been to these press conferences ever since QE began.

Like Wall Street — emerging markets have arguably been propped up by quantitative easing and were wary of it ending. By keeping interest rates low on U.S. Treasury bonds, the Federal Reserve seems to have increased capital flows to emerging markets — places like Latin America, Africa and Asia.

Because of the low interest rates, investors can borrow money cheaply in the United States and then invest it at a higher return in riskier assets abroad. That’s all well and good for the recipient markets — as long as the capital keeps flowing in.

But when tapering causes U.S. interest rates to rise, that “hot money” may flow out of these emerging markets as quickly as it flowed in.

A big deal? First of all, University of Southern California’s Joshua Aizenman said, roughly half of the world’s economic activity comes from emerging markets. These places may seem far-flung to an American audience, but when things go wrong, they’re a lot closer than they appear. Pressure to adjust to abrupt capital outflows strains these countries’ banking systems. A banking crisis, a foreign currency crisis or political upheaval are all plausible in those situations, Aizenman said.

Aizenman is one author of a new working paper from the National Bureau of Economic Research that examines how emerging markets reacted to tapering-related news from the Fed between November 2012 and October 2013. His paper contributes two significant takeaways about the relationship between the American central bank and emerging markets.

The first is about the Federal Reserve itself. Emerging market asset prices responded most to statements about imminent tapering from the Fed chair as opposed to comments from other Fed VIPs. That’s not shocking.

What was surprising, Aizenman said, was their second finding. Tapering news from the Fed more adversely affected emerging markets with “robust” fundamentals (economies with account surpluses, high international reserves and low external debt) than markets with fragile fundamentals.

Why would a robust emerging market suffer more from signs of imminent tapering than a fragile emerging market? Aizenman and his co-authors developed several theories.

The first is that robust countries probably received more capital inflows than other countries because they were robust. These markets had more to lose from tapering because they were exposed to more so-called “hot money” to begin with.

Secondly, unwinding a larger portion of that hot money, Aizenman said, will induce larger price adjustments in markets that are less liquid, which may be the case in some of these robust economies.

And third, stronger economies have lower discount rates, so their stock markets are more attuned to fluctuations in reference interest rates. An increase in U.S. 10-year bond rates, Aizenman explained, would have a much bigger impact on the stock prices of an emerging market where the interest rate on public debt is low than on stock prices in a place with higher interest rates on public debt, like, say, India.

“We are agnostic,” Aizenman said in an interview — not able to determine which explanation is most plausible, in part because the shifting attention span of the global market makes it hard to test fully.

Indeed, adapting a longer time horizon in this study allowed the authors to see that not all emerging markets are affected at the same time. The authors found that while initially, tapering news hit robust emerging economies hardest, several months out, tapering news had actually hit the more fragile emerging markets more. That’s one reason why it’s worth examining markets’ reactions to suggestions of tapering, even after tapering has begun.

What’s the big takeaway? The “Washington consensus,” especially on trade, Aizenman explained, has often been that economic integration benefits emerging markets. But “financial integration is more of a mixed bag,” he said. As America’s central bank, the Fed exercises a dual mandate to maintain robust employment and contain inflation — domestically. But naturally, some emerging economies wish that the Fed’s mandate didn’t also have repercussions for them.

“At this time of instability,” Aizenman said, “one can understand the frustrations of emerging countries that they listened too much to the U.S., and our internal focus is exposing them to new challenges.” Some markets may fear they’ve overexposed themselves to integration, Aizenman noted, and that’s led to an increasing willingness among emerging markets to limit capital inflows.

And yet — nowhere does Aizenman see emerging countries trying to reverse the integration they’ve achieved thus far. So when Yellen next materializes in the Fed’s stately press room, should emerging economies hang on her every word?

Aizenman seems to think that’s just as much a question for the Fed, whose transparency is largely regarded as a virtue. “It raises the question,” he said, “of how much talking a lot may overshoot constructive transparency.”