The Coming U.S. Interest Rate Tightening Cycle: Smooth Sailing or Stormy Waters?

Since the global financial crisis, the policy accommodation by the U.S. Federal Reserve has helped support activity, bolstered asset valuations, and reduced risk premia. In addition, it has been instrumental in lowering long-term interest rates in the United States and other advanced economies. As investors search for higher yields, this policy accommodation has also contributed to an increase in capital inflows to emerging and frontier market economies (EFEs, roughly speaking, developing countries with either substantial or partial access to international capital markets). As a result, borrowing conditions in EFEs have remained particularly favorable. However, the timeframe of the tightening cycle remains uncertain and vulnerabilities in many EFEs have been rising especially over the past two years. The ‘taper tantrum’ episode of May-June 2013 is a painful reminder that even a long-anticipated change in Fed policies can surprise markets in its specifics, and lead to significant financial market volatility and disruptive movements in capital flows to EFEs. This episode was sparked by a statement that became known as ‘taper talk,’ when Fed Chairman Ben Bernanke mentioned the possibility of the Fed slowing its asset purchases ‘in the next few meetings’ on May 22, 2013 (Bernanke 2013b). While financial markets had expected such an action at some point in the future, they were surprised by the mention of an approximate timeframe.