At some point [in the near future] the Fed will begin normalizing monetary policy. In doing so, this will signal many things to many market participants across the globe. From the stand-point of a capital abundant economy, which exports a lot of that capital in search of higher (sometimes risk- adjusted) investment returns, market participants may be inclined to re-patriate a portion of said capital, as they can now earn higher yields at home.
Then there are international investors on a similar hunt for higher yields that will also redirect portions of their investment capital to the US for similar reasons.
All in all, the capital that is bound to flood the shores of the US economy will be corresponding to floods away from the shores of developing and especially emerging economies. These [developing and emerging] economies have collected major dividends from quantitative easing at the Fed and others from the Bank of England to the Bank of Japan, and loose monetary policy from the Bank of Canada to the European Central Bank. As investment yields fell, via interest rates in the developed economies, capital sought new albeit temporary homes.
The recipient economies gladly rolled out the welcome mats, and got to the business of investing the foreign capital. Local currencies would have appreciated against their developed counterparts and trade balances would have worsened as locals could have then afford more relatively cheaper foreign-made goods.
Well it’s time to unwind, and unwind we shall. As investment capital leaves the developing and emerging economies, their local currencies will depreciate, and real interest rates will fall. As the currencies fall, locals will then be able to afford less and less of the now relatively more expensive foreign-made goods. This will result in higher prices or inflation being imported. To deal with increasing price levels, the local central bank or monetary authority can tighten policy by raising nominal interest rates to reduce inflation expectations, as well as manage the exchange rates to influence local price levels.
Tighter monetary policy, however, usually has the effect of slowing growth, as funding for investment in particular becomes more expensive. This tends to spill over into the labor market as local consumption demand and production supply find new equilibria to conform to interest and exchange rates. In most cases people get fired, and it further slows down local demand and hence production supply.
This is where a Keynesian argument can be made for government to step in and offset the tightening of monetary policy. Government can be the investor of last resort. An expansive fiscal policy can buttress the local labor market, and add demand that can bolster local production supply, and in turn bolster more local demand. In a transitory (used loosely) period as this, the local government would be best served by investing in export driven growth, as growth would otherwise consist of expanding the government balance sheet, which is, when it’s all said and done; unsustainable. Support of an export driven government funded growth model would come from the Central Bank as they could manage the slide of the local currency to make local exports more attractive to foreign importers in the developed economies.
The point that can complicate such a simple model, would be the fiscal position of the local government approaching the start of Fed normalization. If the local government has a budget surplus, then they can invest in an export driven growth model without worrying about inflation expectations of foreign investors. But, if the local government is running a budget deficit, and has to borrow to fund its investments, then the credit rating of the government comes into play as well as its level of indebtedness. Too much debt already on the books and investors may demand higher and higher interest rates to lend to that government. At which point, the Central Bank of monetary authority would have to step in and be the lender of last resort to the government which is very inflationary over time, or further raise nominal interest rates to stave off higher price levels.
While the developed economies were muddling through the early days of the Great Recession, emerging and developing economies were benefiting from the then large capital inflows seeking yield. Capital flows that mitigated the impact of the global slowdown and shortages of credit and more importantly liquidity. It may not have been the best time politically to be discussing tightening fiscal policy, but as the tide ebbs so does it flow.
So as the tide of investment capital is getting ready to flow back to the US and other developed economies, as Warren Buffett puts it, “we’ll get to see who was swimming naked”.