With the Federal Reserve playing catch up combatting inflation and commodity prices surging amid Russia’s invasion of Ukraine, investors are on the lookout for signs that the U.S. economy is headed for a recession.
Topping the list is the shape of the U.S. Treasury yield curve, which is on the cusp of inverting. Historically, a yield-curve inversion has been one of the better leading indicators, but it may be less reliable this time.
One reason is that real interest rates (after inflation) are negative, and a U.S. recession has never unfolded in such circumstances. Another reason is that U.S. financial market conditions do not indicate monetary policy is yet restrictive.
My take is that investors should also monitor how emerging economies are faring. The reason: These economies often feel the fallout from Fed tightening when the U.S. economy is weakening, and in several instances they have caused the Fed to back off raising rates.
During the 1970s and early 1980s, for example, the Fed responded to high inflation associated with two oil shocks and surging commodity prices by raising interest rates to record levels. When the U.S. economy entered recession in the second half of 1981, the federal funds rate began to decline. But Federal Reserve chair Paul Volcker did not abandon targeting the money supply until one year later when Mexico, Brazil, Argentina, and other less developed countries were unable to service their debts to multinational banks.
During 1994-95, the Fed under Alan Greenspan tightened policy aggressively as the federal funds rate was increased from 3 percent to 6 percent to ward off inflation. By this time, emerging economies were more reliant on international bonds to finance their external payments imbalances. When the Mexican peso collapsed in late 1994 into 1995, it threatened to generate capital flight throughout Latin America and lead to financial instability. The Fed halted raising interest rates further, and the U.S. economy posted strong economic growth in the second half of the decade as technological advances boosted productivity growth.
In light of these and other experiences, investors need to weigh the possibility that some countries could again experience debt problems. One difference today is that most emerging economies have become less dependent on foreign capital since the Asian Financial Crisis in 1997-98.
Also, the COVID-19 pandemic resulted in steep declines in imports and increased remittances for many Latin American countries that improved their current account positions, and some are now in balance or surplus.
But this does not mean that emerging economies are immune to potential defaults. The latest projections in the International Monetary Fund’s (IMF) 2022 World Economic Outlook call for global growth to be cut in half to 3.6 percent in both 2022 and 2023, while inflation in the advanced economies is expected to reach 5.7 percent this year.
In this context, emerging economies will feel an even greater impact as inflation is expected to average 8.6 percent owing to rising food and energy prices. This will necessitate higher interest rates and cutbacks in government spending.
According to the IMF Financial Stability Report, the COVID-19 pandemic has left emerging-market banks holding record levels of domestic government debt that now average 17 percent of bank assets. This increases the odds that public-sector finances could threaten financial stability if the market value of government debt were to decline as interest rates rise.
The reason is that the loss in value that banks incur on their assets could force them to curtail lending to businesses and households. The risk, in turn, is that a lending slowdown could create a self-reinforcing feedback loop that ultimately leads governments to default.
According to economists Bill Rhodes and John Lipsky, many low-income countries will need to restructure their sovereign debt. The World Bank estimates that 60 percent of this group either suffer from debt distress or are at high risk of doing so. One problem is that pre-existing international mechanisms for dealing with sovereign debt restructuring, such as the Paris Club, have become muddled and ineffective. Also, many of these countries now owe more to China, India, and Saudi Arabia, which have been more reluctant to reschedule debt than western governments.
Nonetheless, while this group of countries will require some debt relief, they are unlikely to affect Federal Reserve policy because U.S. financial institutions do not have significant exposures to them. Historically the countries that have had the greatest impact on U.S. policymakers have been the principal Latin American borrowers—especially Mexico, Brazil, and Argentina—where U.S. institutions have greater exposure. Russia’s default on its sovereign debt in 1998 also resulted in the Fed easing monetary policy when Long Term Capital Management folded and threatened to spread to other financial institutions.
Of these countries, Russia is now on the cusp of default as a result of sanctions imposed after the invasion of Ukraine. This time, however, the Fed is unlikely to respond, as most U.S. institutions have only limited exposure to Russian debt. Meanwhile, Argentina restructured $44.5 billion of debt after it defaulted on a payment in May of 2020, and it is negotiating a new program with the IMF to replace a facility agreed to in 2018.
At some point, Brazil could become a focal point because inflation and interest rates are elevated and it is on the cusp of recession. The unemployment rate reached 11.2 percent in February, and the government’s budget deficit is estimated to approach 8 percent of GDP this year. While Brazil’s currency strengthened against the dollar this past year, it has come under pressure recently amid growing concerns about the economy.
Weighing these considerations, my assessment is that a broad-based debt crisis in emerging economies that have access to international capital markets is not imminent, although cracks are surfacing in some economies. Nonetheless, they will not deter the Fed from raising interest rates aggressively this year.
A version of this article was posted to TheHill.com on April 29, 2022.