The Growth-Interest Rate Cycle in the United States and its Consequences for Emerging Markets

At the time of writing there were widespread concerns about the health of the U.S. economy. There is conclusive evidence that the pace of growth has slowed, which has prompted the Federal Reserve to cut interest rates on two occasions (a total of 100 basis points thus far). As usual, when faced with this kind of turning point, analysts and policy makers alike wonder whether the United States will achieve a “soft landing” or whether the downturn is more serious and protracted—in the worst scenario, the new weakness could signal the end of the new economy. Furthermore, recent inflation surprises have not been encouraging, as higher-thanexpected inflation numbers may curtail the Federal Reserve’s desire and ability to act countercyclically. In this paper, we do not attempt to provide any insights into what lies ahead for the U.S. economy. Our focus is on gaining a better understanding of how the U.S. business cycle, its associated monetary policy cycle, and their interaction affect developing countries. The question of North-South linkages is hardly a new one; the role of trade and primary commodity markets in linking developed and developing countries has a long history (see, for instance, Prebisch, 1950 and Singer, 1950). The links between debtor and creditor nations are also not new (see Diaz- Alejandro, 1984, Dornbusch, 1985, and Calvo, Leiderman, and Reinhart, 1993). Indeed, what is “new” is that some links that had been thought to be extinct have revived in recent years while some “old” links have weakened. As Bordo and Eichengreen (1998) observe, the decade of the 1990s shares some of the features of an earlier age of globalization and high capital mobility prior to World War I; namely, portfolio capital flows to emerging markets have re-emerged as an important link between northern lenders and southern borrowers. This revival is particularly pronounced in the larger Latin American countries. Some of the traditional links, however, may have weakened, as many countries in Asia and Latin America have successfully diversified their exports away from primary commodities. Hence, terms-of-trade shocks may (in some cases) play a smaller role today than in the past. Both of these observations would suggest that, in general, trade/commodity price links may have weakened while financial links may have become stronger. However, one must be cautious in interpretation owing to the large variation across countries in the degree of trade and capital market integration. While the share of primarycommodities in Mexico’s exports has declined dramatically in the past 30 years, the importance of U.S. markets, owing to NAFTA, has soared, which suggests that the trade channel is quantitatively important in the Mexican case.2 These are the questions we analyze. Our focus is on how developments in the United States affect capital flows and growth in emerging market countries across various regions and country groups.