Trade Labour and Trust

From The IMF Blog.

Every two years, the IMF and World-Bank invites global labor union leaders to discuss the global economy and the implications for the labor force. In this podcast, Sharan Burrow, head of the world’s largest trade union federation, says collective action is needed to help better distribute the benefits of growth, if institutions are to regain trust from working people.

Sharan Burrow is General Secretary of the International Trade Union Confederation, and in this podcast she says collective action is needed to help better distribute the benefits of growth.

As head of the world’s largest trade union federation, Burrow lays out—in no uncertain terms, what today’s “stagnating” economy means for the 3 billion people in the global workforce. “It’s certainly not delivering jobs—even where there is growth, particularly for women and young people who are extraordinarily vulnerable.”

While Burrow supports trade and globalization, she says it’s been built on a low wage, labor arbitrage system that has left too many people in insecure and unsafe work.

Burrow also talks about how women’s workforce participation—after having grown significantly in recent years—has come to a near halt, and points out how this is counter-productive.

“The two most significant areas of growth for jobs is investment in infrastructure, and for immediate productivity gains—it’s women’s participation in work,” she added.

Islamic Banking Proposals Get IMF Approval

From IMF Direct.

Islamic banking, a small but fast-growing corner of the financial world, is receiving greater attention from regulators and policy makers. The IMF recently adopted a set of proposals on Islamic banking and called for a more comprehensive set of policies to ensure financial stability in countries with Islamic banking and support the sound development of the industry. The IMF is now calling for additional work and cooperation by its staff with other international agencies to improve the adoption of relevant standards for Islamic banking and to address remaining regulatory gaps. 

The industry mushroomed to more than $1.5 trillion in assets last year from about $100 billion in the late 1990s and now has a presence in 60 countries, mostly in the Middle East and South and Southeast Asia, but increasingly in Africa, Central Asia, and Europe. While it represents less than 2 percent of global banking assets, its share is much bigger in many countries and has become systemically important (meaning its assets account for more than 15% of the total) in 14 of them, including Malaysia, Kuwait, and Saudi Arabia.

Islamic banking in numbers

Islamic banking refers to financial services that conform with Islamic finance principles, which bans interest, excessive speculation, gambling and short-sales; requires fair treatment; and institutes sanctity of contracts.Islamic banking has the potential to make financial services more widely available to people who are currently underserved and to support economic development. What’s more, its guiding principles can promote financial-sector resilience. Yet the industry’s rapid growth and characteristics that distinguish it from conventional banking pose challenges for supervisors and central bankers. As a result, there is broad international recognition of the need for a policy framework and an environment that promotes the financial stability and development of the industry.

International norms

For more than a decade, the Kuala Lumpur-based Islamic Financial Services Board has led efforts to develop regulatory and supervisory standards that complement existing international norms in areas relevant to Islamic banking. This process culminated in 2015 with the development of the “Core Principles for Islamic Finance Regulation” for banking. Now the challenge will be to ensure that these standards are applied broadly and consistently.

A number of other important areas still need to be addressed. These include developing robust resolution regimes (to deal with failing banks) and other financial safety nets and expediting the issuance of high-quality liquid assets such as sovereign Sukuk, a type of government-issued security. Finally, the recent emergence of hybrid financial products that replicate aspects of conventional finance in an Islamic banking context have raised new and complex risks that remain to be addressed by regulators.

Navigating The New Moderate

The IMF, alongshore its release today published a report on aspects of the Australian economy, looking mainly at the labour market, monetary policy and Government debt. It makes salutary reading. Its a big report, but the main take-outs on our reading are:

Labour Market

Though we seem to have managed to keep unemployment under control though the mining downturn, under-employment and static income growth are the consequences. This will continue for some time.

However, long term unemployment has risen and unemployment is higher than consistent with labor market equilibrium.

Monetary Policy

Growth will remain sluggish, and the RBA may need to cut rates further, but the net effect will be to smooth the outcomes, but not enough to reverse the growth trend. The IMF suggest the equilibrium interest rate has declined from around 2% to 1% now.

The policy rate has been below the equilibrium throughout most of the post-GFC recovery, indicating that monetary policy has been in a ‘loose’ stance.

The IMF also says there is room for greater policy transparency from the RBA.

Fiscal Policy

In recent years, the repeated ambitious fiscal consolidation to reach medium-term fiscal targets under a slowly recovering economy highlights the traditional focus on medium term fiscal objectives.  Ambitious budget repair strategy risks being destabilizing in the short term.

Whilst, budget repair is required to return to the Government’s medium-term balance anchor, its pace is in question. The Government will find it difficult to reduce debt in the short to medium term. The IMF says a flexible long-term debt anchor can reinforce the commitment to debt sustainability under both temporary and persistent shocks and still allow for fiscal policy to a play a role in short-term macroeconomic stabilization. The medium-term budget balance anchor is less robust in
maintaining long-term sustainability in the face of persistent negative shocks.


IMF Says Australia’s Housing and Debt Risks Remain

On February 3, the Executive Board of the International Monetary Fund (IMF) concluded the 2016 Article IV consultation with Australia.

Australia has enjoyed robust growth despite the commodity price and mining investment bust. The moderate impact of the large shocks since 2011 highlights the resilience of the economy and strong policy frameworks. From mid-2015, the recovery advanced with a marked pickup in activity, although underlying demand growth remained close to trend. Nevertheless, Australia has not been immune to some elements of the “new mediocre.” Wage and price pressures have been weak, underemployment has risen, and private business investment outside mining has been lackluster.

By some metrics, housing market conditions have cooled, in tandem with intensified prudential and regulatory steps, but risks related to house price and debt levels remain. In the continued low interest rate environment, house prices and household debt have risen further but house price growth has moderated. Intrinsic housing market risks are localized. Bank lending to household has slowed, especially in riskier loans, and banks have strengthened their balance sheets.

With inflation below the target range of 2-3 percent and a downshift in the path of inflation expectation in 2016, the Reserve Bank of Australia (RBA) lowered its policy rate by another 50 basis points to 1.5 percent. Core inflation has since stabilized at around 1.6 percent. Wage growth has remained weak, with nominal unit labor costs running at less than 0.5 percent on average, and cost pressures have been virtually absent suggesting that some economic slack is still present.

The federal government has recently aimed for substantial near-term fiscal consolidation but budget targets have not been met because of weaker nominal income. In the FY2016/17 budget, the government has projected a return to fiscal balance by FY2020/21. It has renewed its commitment to a federal government surplus of 1 percent of GDP over the business cycle as a medium-term fiscal anchor, which would imply a cumulative adjustment of up to 3.4 percent of GDP. The Mid-Year Economic and Fiscal Outlook 2016-17 (MYEFO) foresees a cumulative adjustment of the fiscal balance of 2.1 percent of GDP by end of FY2019/20, primarily related to stronger personal income tax collection due to bracket creep.

Recent structural reforms have focused on fostering innovation. The National Innovation and Science Agenda (NISA) includes measures to boost innovation and entrepreneurship in the high-tech sector, including through tax breaks. Legislation is being prepared for key components of the Harper Review, which has identified a number of reforms to boost competition and productivity in the services sectors, and to strengthen competition policy broadly.

Executive Board Assessment 

Executive Directors noted that Australia’s robust economic growth and low unemployment during the current terms-of-trade adjustment reflect the resilience of the economy and strong policy frameworks. While the balance of risks to the growth outlook has improved, there remain significant risks and uncertainties, notably weaker-than-expected domestic consumption, housing-related vulnerabilities, the rise in protectionist policies in the global economy, and a significant slowdown in Australia’s main trading partners. Against this background, Directors stressed the importance of maintaining supportive macroeconomic policies, addressing macro-financial vulnerabilities, and boosting long-term potential growth.

Directors noted that continued demand support is needed to ensure a smooth transition to non-mining growth. They agreed that, with inflation below target, still elevated underemployment, and remaining economic slack, the monetary policy stance should remain accommodative. Directors welcomed the authorities’ readiness to ease monetary policy further if warranted, and encouraged steps to improve policy communication.

Directors supported the government’s plans to balance its budget over four years and make its expenditure composition more growth-friendly. Many Directors saw scope for using the available fiscal space to support aggregate demand and structural fiscal reforms, as well as increase infrastructure investment. Many other Directors viewed the authorities’ front-loaded consolidation path as appropriately prudent under the current circumstances. Directors welcomed the intention to take a flexible approach if large downside risks materialize, noting that contingency plans would also be helpful. While the current medium-term fiscal framework has served the economy well, Directors recommended that the authorities continue to consider options to strengthen it further.

Directors commended the progress in enhancing prudential and regulatory measures to mitigate risks associated with the housing market, and in improving AML/CFT safeguards in the real estate sector. They encouraged the authorities to remain vigilant and continue to enhance the resilience of the banking system to shocks with macro-financial implications, including by encouraging banks to strengthen their capital position. Financial regulatory authorities would need to stand ready to intensify targeted prudential measures, if lending or house price growth were to re-accelerate, while advancing the implementation of the regulatory reform agenda.

Directors welcomed the government’s structural reform agenda to boost productivity through fostering innovation and strengthening competition, especially in the services sector. They commended the authorities for their commitment to an open economy in trade, foreign investment, and immigration.

The Case For “Inclusive Growth”

From the IMF Blog.

Four years ago, at the World Economic Forum in Davos, IMF Managing Director Christine Lagarde warned of the dangers of rising inequality, a topic that has now risen to the very top of the global policy agenda.

While the IMF’s work on inequality has attracted the most attention, it is one of several new areas into which the institution has branched out in recent years. A unifying framework for all this work can be summarized in two words: Inclusive growth

We want growth, but we also want to make sure:

  • that people have jobs—this is the basis for people to feel included in society and to have a sense of dignity;
  • that women and men have equal opportunities to participate in the economy—hence our focus on gender;
  • that the poor and the middle class share in the prosperity of a country—hence the work on inequality and shared prosperity;
  • that, as happens, for instance when countries discover natural resources, wealth is not captured by a few—this is why we worry about corruption and governance;
  • that there is financial inclusion—which makes a difference in investment, food security and health outcomes; and
  • that growth is shared just not among this generation but with future generations—hence our work on building resilience to climate change and natural disasters.

In short, a common thread through all our initiatives is that they seek to promote inclusion—an opportunity for everyone to make a better life for themselves.

These are not just fancy words; a click on any of the links above shows how the IMF is making work on inclusion a part of its daily operations.

Inclusion is important, but so of course is growth. “A larger slice of the pie for everyone calls for a bigger pie” (Lipton, 2016). So when we push for inclusive growth, we are not advocating as role models either the former Soviet Union or present day North Korea—those are examples of ‘inclusive misery,’ not inclusive growth. Understanding the sources of productivity and long-run growth—and the structural policies needed to deliver growth—thus remains an important part of the IMF’s agenda.

Globalization and inclusion

The IMF was set up to foster international cooperation. Hence, to us, inclusion refers not just to the sharing of prosperity within a country, but to the sharing of prosperity among all the countries of the world. International trade, capital flows, and migration are the channels through which this can come about. This is why we stand firmly in favor of globalization, while recognizing that there is discontent with some of its effects and that much more could be done to share the prosperity it generates.

Higher growth should help address some of the discontent, as argued by Harvard economist Benjamin Friedman in his book, The Moral Consequences of Economic Growth. Friedman shows that, over the long sweep of history, strong growth by “the broad bulk” of a society’s citizens is associated with greater tolerance in attitudes towards immigrants, better provision for the disadvantaged in society, and strengthening of democratic institutions.

However, designing policies so they deliver inclusive growth in the first place will be a more durable response than leaving matters to the trickle-down effects of growth.

Policies for inclusive growth

♦  Trampolines and safety nets: “More inclusive economic growth demands policies that address the needs of those who lose out … Otherwise our political problems will only deepen” (Lipton, 2016). Trampoline policies such as job counseling and retraining allow workers to bounce back from job loss: they help people adjust faster when economic shocks occur, reduce long unemployment spells and hence keep the skills of workers from depreciating. While such programs which already exist in many advanced economies, they deserve further study so that all can benefit from best practice. Safety net programs have a role to play too. Governments can offer wage insurance for workers displaced into lower-paying jobs and offer employers wage subsidies for hiring displaced workers. Programs such as the U.S. earned income tax credit should be extended to further narrow income gaps while encouraging people to work (Obstfeld, 2016).

♦  Broader sharing of the benefits of the financial sector and financial globalization: We need “a financial system that is both more ethical and oriented more to the needs of the real economy—a financial system that serves society and not the other way round” (Lagarde, 2015). Policies that broaden access to finance for the poor and middle class are needed to help them garner the benefits of foreign flows of capital. Increased capital mobility across borders has often fueled international tax competition and deprived governments of revenues (a “race to the bottom leaves everyone at the bottom,” (Lagarde, 2014). The lower revenue makes it harder for governments to finance trampoline policies and safety nets without inordinately high taxes on labor or regressive consumption taxes. Hence, we need international coordination against tax avoidance to prevent the bulk of globalization gains from accruing disproportionately to capital (Obstfeld, 2016).

♦  ‘Pre-distribution’ and redistribution: Over the long haul, polices that improve access to good education and health care for all classes of society are needed to provide better equality of opportunity. However, this is neither very easy nor an overnight fix. Hence, in the short run, ‘pre-distribution’ policies need to be complemented by redistribution: “more progressive tax and transfer policies must play a role in spreading globalization’s economic benefits more broadly” (Obstfeld, 2016).

Are Small Business Bearing Some Of The Bank’s Interest Rate Risk?

An interesting working paper from the IMF was released today. Why Do Bank-Dependent Firms Bear Interest-Rate Risk? looks at the link between bank funding, floating rates and how this is transmitted to firms who borrow on variable rate terms. The paper concludes that banks do indeed transfer interest rate risks to firms, and this is especially so when banking regulation tightens.

Here is the summary:

I document that floating-rate loans from banks (particularly important for bank-dependent firms) drive most variation in firms’ exposure to interest rates. I argue that banks lend to firms at floating rates because they themselves have floating-rate liabilities, supporting this with three key findings. Banks with more floating-rate liabilities, first, make more floating-rate loans, second, hold more floating-rate securities, and third, quote lower prices for floating-rate loans. My results establish an important link between intermediaries’ funding structure and the types of contracts used by non-financial firms. They also highlight a role for banks in the balance-sheet channel of monetary policy.

Here is the full conclusion from the report:

Bank lending is in large part funded with floating-rate deposits. As hedging is costly, banks avoid mismatch with the interest-rate exposure of their liabilities, in part, by making floating-rate loans to firms. To establish this link between the structure of bank liabilities and the floating-rate nature of bank lending, I examine the cross section of banks. Banks with greater interest rate pass-through on their deposits hold more floating-rate assets: both loans and securities. In the cross section, these floating fractions are positively correlated with each other. I show that if banks were responding to demand for floating-rate debt from firms instead of their own liabilities, this correlation would be negative.

Moreover, while banks with more deposit pass-through hold more floating-rate loans, they quote lower interest rates for ARMs relative to FRMs. The combination of higher quantities and lower prices points to variation in supply rather than demand. I also present time series and historical evidence supporting the supply-driven view of floating-rate bank lending to firms.

This paper therefore highlights an important consequence of banks’ short-term funding: the potential for interest-rate mismatch. While standard models do analyze maturity mismatch created by short-term funding, they typically do not consider uncertainty in interest rates and interest-rate mismatch.

This paper shows that the structure of banks’ funding has important implications for the choices banks make about interest-rate risk on the asset side of their balance sheets. More broadly, my results establish an important link between intermediaries’ funding structure and the types of contracts used by non-financial firms. My results suggest that tighter regulation of banks’ exposure to interest rates might lead banks to pass on more risk to firms, which is particularly relevant given renewed regulatory focus on banks’ exposure to rates.

Bank-dependent firms, i.e. poorly rated firms and smaller firms, are more exposed to interest rates than firms with better access to capital markets. While these firms do use interest-rate derivatives to hedge this exposure, they do so only partially. I show that this exposure is a component of the Bernanke & Gertler (1995) balance-sheet channel of transmission of monetary policy. Banks therefore play a role in the transmission of monetary policy to firms beyond the usual bank lending channel; here the effect is based on existing rather than new bank lending.

Note: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

The Global Economic Landscape Has Started Has to Shift

From iMFDirect.

Today we released our update to the World Economic Outlook.

An accumulation of recent data suggests that the global economic landscape started to shift in the second half of 2016. Developments since last summer indicate somewhat greater growth momentum coming into the new year in a number of important economies. Our earlier projection, that world growth will pick up from last year’s lackluster pace in 2017 and 2018, therefore looks increasingly likely to be realized. At the same time, we see a wider dispersion of risks to this short-term forecast, with those risks still tilted to the downside. Uncertainty has risen. 


Our central projection is that global growth will rise to a rate of 3.4 percent in 2017 and 3.6 percent in 2018, from a 2016 rate of 3.1 percent. Much of the better growth performance we expect this year and next stems from improvements in some large emerging market and low income economies that in 2016 were exceptionally stressed. That being said, compared to our view in October, we now think that more of the lift will come from better prospects in the United States, China, Europe, and Japan.

A faster pace of expansion would be especially welcome this year: global growth in 2016 was the weakest since 2008–09, owing to a challenging first half marked initially by turmoil in world financial markets. General improvement got under way around mid-year. For example, broad indicators of manufacturing activity in emerging and advanced economies have been in expansionary territory and rising since early summer. In many countries, previous downward pressures on headline inflation weakened, in part owing to firming commodity prices.

A significant repricing of assets followed the U.S. presidential election. Its most notable elements were a sharp increase in U.S. longer-term interest rates, equity market appreciation and higher long-term inflation expectations in advanced economies, and sharp movements in opposite directions of the dollar—up—and the yen—down. At the same time, emerging market equity markets broadly retreated as currencies weakened.

Of course, asset markets adjust not just to unexpected current events, but to shifting expectations of future events. Most commentators have interpreted the post-election moves as predicting that U.S. fiscal policy will turn more expansionary and require a swifter pace of interest rate increases by the Federal Reserve. Markets have noted that the White House and Congress are in the hands of the same party for the first time in six years, and that change points to lower tax rates and possibly higher infrastructure and defense spending.

In light of the U.S. economy’s momentum coming into 2017, and the likely shift in policy mix, we have moderately raised our two-year projections for U.S. growth. At this early stage, however, the specifics of future fiscal legislation remain unclear, as do the degree of net increase in government spending and the resulting impacts on aggregate demand, potential output, the Federal deficit, and the dollar.

There is thus a wider than usual range of upside and downside risks to this forecast. A sustained non-inflationary growth increase, marked by higher labor force participation and significant expansion of the U.S. capital stock and infrastructure, would allow a more moderate pace of interest rate increases in line with the Federal Reserve’s price stability mandate.

On the downside, if a fiscally-driven demand increase collides with more rigid capacity constraints, a steeper path for interest rates will be necessary to contain inflation, the dollar will appreciate sharply, real growth will be lower, budget pressure will increase, and the U.S. current account deficit will widen.

This last scenario, one with a widening of global imbalances, intensifies the risk of protectionist measures and retaliatory responses. It would also imply a faster than expected tightening of global financial conditions, with resulting possible stress on many emerging market and some low-income economies. Some emerging and especially low-income commodity exporters could benefit from higher export prices, but importers would then lose. The details of the U.S. policy mix matter; and as these become clearer, we will adjust our forecast and spillover assessment.

Among emerging economies, China remains a major driver of world economic developments. Our China growth upgrade for 2017 is a key factor underpinning the coming year’s expected faster global recovery. This change reflects an expectation of continuing policy support; but a sharp or disruptive slowdown in the future remains a risk given continuing rapid credit expansion, impaired corporate debts, and persistent government support for inefficient state-owned firms.

At the global level, other vulnerabilities include higher popular antipathy toward trade, immigration, and multilateral engagement in the United States and Europe; widespread high levels of public and private debt; ongoing climate change—which especially affects low-income countries; and, in a number of advanced countries, continuing slow growth and deflationary pressures. In Europe, Britain’s terms of exit from the European Union remain unsettled and the upcoming national electoral calendar is crowded, with possibilities of adverse economic repercussions, in the short and longer terms.

We continue to recommend a three-pronged policy approach relying on fiscal and structural policies alongside monetary policy, but one that is tailored to country circumstances.

Some advanced economies are now operating at close to full capacity, for example, Germany and the United States. In these, fiscal policy should focus, not on short-term demand support, but on increasing potential output through investments in needed infrastructure and skills, as well as supply-friendly, equitable tax reform. Policymakers in these economies should also turn their attention to longer-term fiscal sustainability, while monetary policy can follow a data-dependent normalizing path.

Structural reform remains a priority everywhere in view of continuing tepid productivity growth, although in many cases appropriate fiscal support can raise the effectiveness of reforms without worsening governments’ fiscal positions.

Financial resilience is another universal priority and requires stronger financial regulatory frameworks, better focused on key problem areas. Countries can do much on their own to improve financial oversight and institutions, but not everything, and continuing multilateral financial regulatory cooperation is vital.

Social dislocation due to globalization and, even more, to technology change is a major challenge that will only intensify in the future. One result has been wider inequality and wage stagnation in many countries. Rolling back economic integration, however, would impose aggregate economic costs without reducing the need for government investment in well-trained, nimble workforces, along with policies to promote better matching of available jobs to skills.

On this Martin Luther King Jr. Day in the United States, we do well to acknowledge a key takeaway from 2016: sustainable growth must also be inclusive growth.


What the Fed Rate Rise Means for Corporate Debt in Emerging Markets

From The IMF Blog.

In December 2016, the U.S. Fed raised interest rates for the first time in a year, and said they planned more increases in 2017.  Emerging market currencies took a bit of a dive, but overall investors didn’t overreact and run for the doors with their money.  For the bigger picture, you can read IMF Chief Economist Maurice Obstfeld’s blog that outlines how the U.S. election and Fed decision will impact the global economy.

One aspect that makes emerging markets more vulnerable is their corporations are loaded down with debt in both local and foreign currency—to the tune of roughly $18 trillion—fueled in large part by low interest rates in the United States.  This debt now makes them vulnerable to the expected interest rate increases in 2017. Will firms be able to roll over their debt?

The debt balloon

The debt of nonfinancial firms in emerging markets has quadrupled over the past decade, with bonds accounting for a growing share (Chart 1). The considerable increase in corporate debt raises concerns, given the link between the rapid build-up in leverage in emerging markets and past financial crises.


Our new paper suggests that:

  • Debt accumulation was more pronounced for firms which are more dependent on external financing. Likewise, relative to other types of firms, small and medium-sized enterprises disproportionately increased their leverage.
  • The impact of U.S. monetary policy on debt growth was greater for sectors that are more heavily dependent on external funding in financially open emerging markets with relatively more rigid exchange rate regimes.
  • Global financial conditions affected emerging market firms’ growth in debt in part by relaxing corporate borrowing constraints.

Where is debt highest

Corporate debt in emerging markets has climbed faster in more cyclical sectors, with the greatest growth seen in construction (Chart 2). The striking increase in leverage within the construction sector is most notable in China and Latin America. In addition, firms that took on more debt have, on average, also increased their foreign exchange exposures.


Commodity Commotion

From the iMFdirect Blog.

Terms of trade is the price of a country’s exports relative to its imports. The commodity terms of trade refers to a country’s commodity exports relative to its commodity imports.

When the price of commodities, like oil, plummeted in 2015, economies that rely on exporting commodities had their terms of trade drop by an average of about 10 percent of GDP that year. Economies that rely more on importing commodities saw about a 2 percent of GDP benefit from the 2015 drop in prices.


The decline in commodity prices may finally be leveling off, and instead of the spring 2016 World Economic Outlook projections of another 2 percent decrease in the terms of trade for commodity-exporting countries in 2016, the decline on average is estimated to have been closer to ½ percent of GDP. Although this is good news for those economies, it doesn’t do much to help recuperate the losses suffered in 2015.

The flip side is that the gains reaped by commodity-importing economies in 2015 are now looking to be short lived. The IMF estimates the benefit to these economies to have increased by less than ¼ percent in 2016: less than half the projected ½ percent anticipated in the spring 2016 World Economic Outlook projections.

A Shifting U.S. Policy Mix: Global Rewards and Risks

From The  iMFdirect Blog.

After a year marked by financial turbulence, political surprises, and unsteady growth in many parts of the world, the Fed’s decision this month to raise interest rates for just the second time in a decade is a healthy symptom that the recovery of the world’s largest economy is on track.

The Fed’s action was hardly a surprise: markets had for weeks placed a high probability on last week’s move. But market developments preceding the Fed decision did surprise many market watchers.

Especially striking were the sharp upward moves in longer-term U.S. interest rates, the dollar, and market-based measures of long-term inflation expectations soon after the U.S. presidential and congressional elections of November 8. No comparably abrupt market reactions preceded the Fed’s previous interest rate hike of December 2015 (see chart).

The dollar has risen further in the days following the Fed’s recent move.

usintrates-chartTime will tell if these market developments point to a new trend. Most likely, however, the election marks a shift in the U.S. policy regime with potentially even bigger future effects on prices and activity—abroad, as well as in the United States. Spillovers outside the United States will be felt especially strongly in emerging market economies, where for some, the advantages of enhanced competitiveness due to weaker currencies may be finely balanced against vulnerabilities.

Something has changed

From the start of 2016 and through the U.S. election, Treasury yields had been particularly low. Discussion of the global outlook, including at the IMF, stressed the risks of protracted low growth and continuing deflation pressures—even secular stagnation, with persistently low interest rates.

Longer-term nominal interest rates are, however, strongly influenced by expectations of the future path of the Fed’s policy rate, which in turn responds to U.S. inflation pressures and the economy’s underlying strength. Thus, the sharp post-election turnaround in longer-term U.S. interest rates changed the conversation: it likely reflected not the looming December rate hike alone, which was already widely anticipated, but also a shift in expectations about the future interest rate path and future demand in the U.S. economy.

Consistent with those expectations, while last week’s interest-rate hike was itself not unexpected, the future path of interest rates that Federal Open Market Committee members anticipate also steepened, and now suggests three interest rate hikes in each of the next two years.

The timing of the abrupt asset-price movements—coming within days of the U.S. election—is the key clue about what moved markets. The election of Donald Trump as president, coupled with continuing Republican control of the Congress, ended six years of divided U.S. government.

Implications for the future

Republicans in Congress have long advocated lower personal and corporate tax rates. President-elect Trump campaigned on a platform that included not only substantial tax cuts, but also increases in some categories of government spending, notably defense and infrastructure.

At this early stage, it is hard to know precisely how the shift in fiscal policy will look. One thing seems clear, however: it will turn more expansionary through some combination of more spending and lower tax rates.

In general, any increase in U.S. aggregate demand will generate some rise in real output—as new workers are hired, others work longer hours, and machinery is used more intensively—and some upward pressure on inflation. With the overall unemployment rate at 4.6 percent and other measures of labor market distress largely recovered from the financial crisis eight years ago, there could be little remaining slack in the U.S. economy. Unless labor force participation and overtime work rise significantly, there is a chance that inflation pressure therefore rises noticeably. This seems to be what the Fed has in mind when it predicts it will raise the federal funds rate more quickly.

More rapidly rising U.S. interest rates signal further dollar appreciation. Tax incentives for U.S. corporation to repatriate their past profits held abroad, which some estimate at $2.5 trillion, could also push the dollar up. Given faster demand growth, the outcome will be a widening U.S. current account deficit, that is, more borrowing from abroad. Some of it will possibly finance a growing Federal fiscal deficit, depending on the precise features of the U.S. fiscal package, the extent to which it is paid for by budget cuts elsewhere, the path of government borrowing rates, and the economy’s growth response.

U.S. growth will respond more strongly, with lower inflation, if any infrastructure spending is carefully designed to boost potential output, while tax measures encourage investment, labor supply, and inclusion.

International challenges ahead

Given the United States’ central role in the world economy, big changes in its policy mix have first-order effects beyond its borders.

Advanced economies with currencies that depreciate against the dollar will benefit both from higher U.S. growth and from more competitive exchange rates. For most of these economies, currently struggling with below-target inflation, any resulting inflationary pressure would (at least initially) be welcome. They may also see upward pressure on interest rates, posing a fiscal challenge for countries that are highly indebted but do not benefit enough from the positive demand spillovers that are driving their interest rates upward.

Emerging market economies can also benefit from more competitive currencies and higher U.S. demand. But although many emerging market economies have increased their policy buffers (e.g., foreign reserves), reduced currency mismatches, and improved financial oversight frameworks, some could still feel stress, especially where there are pre-existing political or economic strains.

Historically, U.S. interest rates have been one of the key drivers of net capital flows into emerging market economies. Flexible exchange rates can be helpful as a buffer against rapid outflows, as they allow international portfolios to rebalance through currency changes rather than reserve losses. A combination of rising dollar interest rates and domestic currency depreciation could reduce liquidity or worsen balance sheets, however, especially given the importance of dollar borrowing by residents and non-resident corporates in emerging market economies. Furthermore, currency depreciation might spark higher inflation. Policymakers in emerging markets therefore will remain vigilant.

If sharp exchange rate shifts and growing global imbalances follow the U.S. policy regime change, protectionist pressures become a major risk, as in past similar circumstances. Given the desire of advanced economy governments to maintain manufacturing, where emerging markets have made big inroads in recent decades, it is most likely that emerging market economies are the main targets for higher trade barriers erected by advanced economies.

Governments should therefore keep in mind that protection is likely to be counterproductive at home—even before trade partners retaliate, as they will be tempted to do. The integration of advanced economies into truly global supply chains underscores this danger. In an environment of sharply divergent policy mixes, as we may now be facing, the rules of the global trading system will be more important than ever.

Watch our recent video explaining how interest rates work: