About Those High Interest Rates

I’ve recently read lots of articles claiming that the emerging markets are being hurt by the high interest rate policy of the Fed.  Obviously they don’t mean short-term rates, which are near zero, but rather long-term rates.  But 10 year bond yields are 2.6%.  Since when does 2.6% 10-year yields prevent EMs from achieving prosperity?  Those are amazingly low interest rates.  Is there a model that explains why 2.6% 10-year bond yields cause an EM crisis, or are people simply making a correlation ==> causation argument?

Some might argue that while interest rates are a poor indicator of the stance of monetary policy; EMs are nonetheless being hurt by tighter Fed policy.  But if that were true then US NGDP growth should be slowing, whereas it has actually been speeding up slightly.  Don’t get me wrong, I think policy is too tight, and a slightly easier policy would help the EMs.  That’s true and that’s important. But that was even more true a year or two ago when EMs were doing much better.  So why have they done much more poorly in recent months, even as US growth has sped up?

Lars Christensen says EMs need to make sure NGDP growth stays fairly stable, and I agree.  He points to Colombia as a country that is responding in the correct way to the global EM confidence shock.

I’m also confused by the constant complaints that the Fed is changing its forward guidance.  It’s true that the Fed recently made its forward guidance a bit more specific, and it’s true that the forward guidance is far from optimal.  But they certainly have not made any major changes.  Here’s a typical report:

Its communication strategy has been less than stellar, however. A misstep last summer by former Chairman Ben Bernanke left the markets believing that tightening would come sooner than expected, while recent trends have shown that the Fed almost certainly will have to abandon its 6.5 percent unemployment rate target for beginning to consider interest rate hikes.

It did not “abandon” anything last month, it clarified that it would not raise rates until either inflation rose above 2.5% or unemployment fell well below 6.5%.  That’s a more specific guidance than the previous 2.5% inflation/6.5% unemployment threshold.  It’s not clear why the market was confused by this switch, it was entirely rational.  Before the market was uncertain what would happen in the scenario where inflation is 2% and unemployment is around 6.4% or 6.5%.  They didn’t know if the Fed would raise rates in that case or not.  Now the Fed has clarified things, they will not raise rates in that situation. No promise was reneged upon. Indeed it would be better if the Fed dropped the unemployment threshold entirely and went with inflation, or better yet NGDP. But things are slowly improving in the guidance area.

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