Global Economic Repercussions If Federal Reserve Raises Interest Rates


With Federal Reserve Chairman Jerome Powell now leaving little doubt that in the year ahead the Fed will continue to raise interest rates, U.S. policymakers would do well to consider the likely economic impact that these rate increases will have on the economies of countries south of the border. This would seem to be particularly the case considering that it is two of Latin America’s largest economies, Brazil and Mexico, which are likely to be the most impacted by higher U.S. interest rates in the run-up to their presidential elections later this year.

Emerging market economies generally do well when global liquidity is ample and poorly when global liquidity conditions tighten. When global interest rates are as low as they have been these past nine years, the emerging market economies get flooded with money from abroad in search of higher yields. However, when global interest rates start rising, money tends to be repatriated from the emerging markets to the relative safety of the more advanced economies. Oftentimes, it is this capital repatriation that causes the emerging market economies considerable distress, especially if they did not prepare for a rainy day.

As Jerome Powell recognized this week in his congressional testimony, there are good reasons to think that U.S. interest rates are headed considerably higher in the period ahead to prevent the economy from overheating. It is not simply that the U.S. economy is already at or perhaps even beyond full employment and growing at a rate above its longer run potential. Rather, it is that the U.S. economy is now receiving considerable economic stimulus at a time of cyclical strength. It is doing so from unusually accommodative financial conditions, courtesy of buoyant equity prices and a weak dollar, as well as from the Trump tax cuts and public spending increases.

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The prospective rise in U.S. interest rates comes at a particularly inopportune time for Mexico. In July, that country is headed for a presidential election that must be expected to heighten domestic political uncertainty. This is particularly the case considering that Andres Manuel Lopez Obrador, a left-leaning radical populist leader, is currently well ahead in the polls. The prospect that Mexico might veer away from market-based economic policies and that it might take a more confrontational approach to its northern neighbor is hardly likely to instill confidence in foreigners, who currently are estimated to own around 40 percent of Mexico’s outstanding government debt.

Another factor likely to accelerate the flow of capital out of Mexico as U.S. interest rates rise is uncertainty over the NAFTA negotiations in the wake of the Mexican election. This is particularly the case considering that the U.S. accounts for around 70 percent of Mexico’s exports and that the election of a less pliable Obrador as president would diminish the chances for a favorable NAFTA deal or for continued U.S. direct investment in that country.

Brazil is perhaps even more vulnerable than is Mexico to capital outflows in response to rising U.S. interest rates. This is not simply because the whole of Brazil’s political class has been tainted by the Petrobras scandal and because Brazil’s October elections are likely to produce a populist president from either the left or the right side of the political spectrum. Rather it is that Brazil’s public finances are in considerable disarray.

With a budget deficit at currently around 9 percent of GDP, Brazil’s public debt is clearly on an unsustainable path. This must raise the real risk that investors could take flight should the Brazilian elections produce a government unwilling or incapable of addressing the country’s public finance problem and defusing its unfunded pension system’s time bomb.

It is in the U.S. interest to have political and economic stability in our backyard. For which reason one has to hope that U.S. policymakers are already starting to think how they might respond to real economic and financial strains in Brazil and Mexico as the Fed proceeds with monetary policy normalization. One must also hope that U.S. policymakers will be supportive of IMF involvement in those countries should that become necessary.



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