Federal Reserve's hesitation brings respite for emerging markets

Like a pilot spotting a smoking engine at take-off, the US Federal Reserve is having second thoughts about when to raise interest rates.

Disappointing growth in the first quarter led the Federal Open Market Committee to turn more cautious over the state of the US economy. Traders had braced themselves for a lift-off in June, but it is now possible the central bank will wait until next year to raise borrowing costs.

The consequences of any delay will be felt well beyond the US. What happens in Washington may change the shape of the global recovery, crushing hopes for a sharp rebound in the eurozone, while removing some of the gloom from the outlook for emerging markets.

The single currency union has enjoyed a steady start of the year thanks to the double boost from low oil prices and the effects of the European Central Bank's quantitative easing programme.

Just as helpful, however, has been the hawkish stance taken so far by monetary policy makers in the US, who have pushed down the euro against the dollar by more than the ECB's actions alone could. For eurozone exporters, this was a timely gift.

It is also one which may not last. On the back of Wednesday's Fed statement, the euro soared to $1.125, a sharp increase from the 12-year low of $1.05 reached in March. European stocks were also quickly in retreat.

Europe's loss, however, may well be Asia's and Latin America's gain. For much of the year, central banks in the emerging world have been cautious about cutting interest rates despite sluggish demand.

hey know inflation has fallen on the back of a lower oil price, a one-off effect, and are fearful of being exposed when the Fed raises rates and drives capital away from frontier markets towards the US.

True, the monetary authorities in countries such as Peru, Thailand and India have all lowered borrowing costs and the People's Bank of China is mulling an ECB-style programme of cheap funding for its banks. However, as Manoj Pradhan, an economist at Morgan Stanley, has noted, real interest rates in several emerging markets have risen because of even sharper falls in inflation.

The Fed's hesitation may open a window of opportunity for emerging markets. The longer it waits before cutting interest rates, the further they can go with loosening monetary policy. The fear of capital outflows has momentarily receded: currencies across Asia and eastern Europe appreciated sharply in April, on the back of renewed investor interest for more exotic assets.

There are limits, however, to what these central banks can do. For a start, as James Daniel and Rachel van Elkan from the International Monetary Fund warned in a blog last month, if Asian countries "were to significantly loosen monetary policy . . . this could foster excessive credit growth". And while increased lending is essential to boost demand, it can lead to large-scale misallocation of capital, as has happened in China since the financial crisis.

Second, emerging markets could still be caught short when the Fed eventually decides to raise rates. US central bankers have shown little regard for the consequences abroad of their monetary policy decisions. In any case, as the president of the New York Fed, William Dudley, noted last month, the US central bank is "still learning how to more effectively communicate".

Emerging markets may find a surprise ally in Europe. A stronger euro would make it harder for the ECB to meet its inflation target of just below 2 per cent. Mario Draghi, ECB president, and his colleagues, would have little option but to continue with their QE programme at least until the scheduled end of September 2016.

European liquidity will offer some cover for emerging markets. But they should not take too much comfort. Fed increases are powerful tsunamis - within hours, their effects are felt even on the furthest shores.

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