Rethinking the Federal Reserve’s mandate: a global perspective

In November 2001, Goldman Sachs economist Jim O’Neill released a report in which he coined the term “BRIC,” referring to the countries Brazil, Russia, India and China. O’Neill predicted that these emerging markets would drive global economic growth over the next decade.

And he was right — for a couple of years at least. Unfortunately, strong growth in the BRIC countries ceased when the global commodity and credit boom, which had started at the beginning of the decade, ended in 2008.

By August 2013, O’Neill felt that to retain its original significance, the acronym should be shortened to “C.” However, at that point in time, economists were shifting their focus to a different group of countries with a new catchy mnemonic.

On Aug. 5, an analyst at Morgan Stanley released a report on the “Fragile Five” — Brazil, India, Indonesia, South Africa and Turkey. These countries all have large government and trade deficits, as well as low growth, higher inflation and rumblings of political instability.

Recently, there has been concern about the ability of the Fragile Five to maintain the capital inflows that have allowed them to run these deficits. This has led to volatility in the valuation of their currencies. For example, the Turkish lira fell 13 percent against the dollar over the past month.

This has prompted interest rate increases of varying degrees by Turkey, South Africa and Indonesia in an attempt to both prevent destabilizing devaluations of their currencies as well as to reign in inflation.

In the midst of this, there have been complaints that the recent decision by the Federal Reserve to cut back on bond purchases has negatively impacted emerging market countries, in particular, the Fragile Five. 

As the Fed aggressively cut interest rates in the face of the recession in 2008, yields on U.S. bonds fell dramatically, which led to increased investment in emerging markets as investors searched for higher yields elsewhere. It was this shift that has allowed the Fragile Five to run large fiscal deficits, in much the same fashion as the United States.

However, as the Fed proceeds with its plan to slow bond purchases, rising yields on U.S. debt will draw back investors. The governor of Brazil’s central bank likened the Fed’s actions to turning on a “vacuum cleaner” that would suck investment out of emerging markets and put them into the United States.

Such a shift would make it much harder for the Fragile Five to run stable deficits. They would have to raise interest rates — as they have started to do already — to continue to attract investors in order to service their debt. 

Currently, it seems like the Fed will remain steadfast in its cutbacks, even in the face of January’s dismal unemployment numbers. Nonetheless, the Fed should take into consideration more than simply the domestic consequences of its tapering program. Not only will it have a negative impact on the Fragile Five and other emerging market countries, it will have a negative impact on the United States as well.

Technically speaking, it is not the responsibility of the Federal Reserve to consider the broader international impact of its actions. The Reserve’s stated objectives are to achieve “maximum employment, stable prices and moderate long-term interest rates,” which is consistent with its mandate as an institution. Note that none of these objectives include international economic stability.

However, it is obvious that the Federal Reserve has a vested interest in maintaining this. It has done so in the past: The bank functioned as the cornerstone of the Bretton Woods system until it fell apart in 1977. Even though it is not the explicit center of the international monetary system as it was under Bretton Woods, the actions of the Fed clearly have a major impact on the financial situation of foreign nations. 

Amidst the recent turmoil, some have argued that despite the concerns of investors, the economic fundamentals of the Fragile Five are sound and no crises are imminent. This might be true, but sound fundamentals cannot fully insulate a country from the possibility of large outflows of short-term debt for two reasons.

First, general bearish investor behavior can lead to large drops in currency valuations and debt troubles, regardless of whether or not this behavior is justified by fundamentals. Additionally, debt crises have historically occurred in particular regions, not in individual countries, as investors extrapolate a weakness in one economy to regional problems. 

This is why we’ve experienced the Latin American Financial Crisis in the 1980s and the Asian Financial Crisis in the 1990s rather than the Brazilian and Thai crises. Now that these five countries have been grouped together as fragile, it is very possible that instability in any one of them could cause a general flight of investors. Market sentiment plays a huge role in the occurrence of fiscal troubles.

Finally, even if the Fed lacks any concern for the international financial system, it still should worry about the eventual fiscal impact a possible debt crisis would have on the United States. Historically, if a country is on the brink of default, it has been because U.S. banks have taken losses and the U.S. government has funded the IMF rescue packages.

As U.S. banks are increasingly exposed to the Fragile Five, this concern is clearly prescient. So perhaps the Fed should reconsider their stance, in the interest of not creating a fractured five.

Write Thomas at teh18@pitt.edu.