Economics 9708/42 — October/November 2016

Risks of reduced US monetary stimulus

The US Central Bank (the Federal Reserve) announced in January 2014 that it would reduce its quantitative easing (QE) by cutting its monthly bond purchases by another $10 billion. It said that it was optimistic that ‘the economy is about to start growing faster and there is underlying strength in the wider global economy’. It had set interest rates near to zero.

This policy of the Federal Reserve contributed to a global shift in investments. Turkey, for example, which depends heavily on foreign investment, tried to bolster its currency by raising its interest rate to attract funds, but this did not work.

The Federal Reserve, however, was thought to be unlikely to adjust its own policy in response to the problems in other countries unless it saw evidence that the problems were affecting the US domestic economy. Indeed the problems in countries such as Turkey may have made it easier for the Federal Reserve to reduce its expenditure on bonds. Investors seeking to limit their risks were bidding up the price of US bonds, counteracting the effects of the Federal Reserve’s gradual reduction in the volume of its own purchases.

The prospect of a future rise in US interest rates caused worrying declines in investment in emerging markets. China’s Deputy Finance Minister argued that the US has a responsibility beyond its own domestic economic concerns, saying ‘We hope that as the issuing country of the largest reserve currency in the world the US should be mindful of the wider effects of its macroeconomic policies’.

The Deputy Finance Minister added that balance of payments problems in the developing world are partly due to lack of domestic economic reform there. This was supported by a British official who said that emerging economies had been helped by cheap money from the advanced countries but this disguised the need to follow through on fundamental reforms in some countries. Currencies of countries such as India, Indonesia, Turkey and Brazil have been under particular pressure because of their current account deficits.

A US official said that strong US growth is good for the global economy and responded to criticism of the Federal Reserve’s handling of QE: ‘I think that what has been demonstrated is that we’ve pursued a pro-growth policy that we believe is ultimately good for the global economy. Because when the US economy is growing, it helps to provide momentum more broadly’.

Source: International New York Times, 30 January 2014