Fed Rate Hikes & Emerging Economies

Last week the minutes to the Federal Open Market Committee’s May meeting were released with support that the Fed will increase interests rates in June if the economy continues to show signs of growth. The U.S. jobs report on Friday is expected to bolster confidence for the rate hike. With higher interest rates coming soon conversation often spurs on the effect dollar appreciation will have on emerging-market economies.

Standard economic theory suggests that if U.S. interest rates increase dollar value increases since foreign investors gravitate towards U.S. markets for greater rates of return. Demand for the dollar increases as investors must convert their local currency into dollars, consequently creating a plethora of predicaments for developing economies with high dollar-denominated debt. Within the past year America’s dollar has gained 82% on the Turkish Lira, 93% on the Philippine Peso, and 96% on the Malaysian Ringgit— with dollar appreciation these rates increase as foreign currencies decrease in value and debt in U.S. dollars becomes more expensive.

Lira vs. Dollar over 1 year

However, the question stands, do rate hikes have tangible effects on dollar valuation? Richard A. Meese and Kenneth Rogoff’s study, Empirical Exchange Rate Models of the Seventies: Do they fit out of sample? says otherwise. While this paper is filled with all sorts of econ goodness, its primary “random walk” model shows that, in the short run, exchange rates are essentially unpredictable, the current value of these rates acting as the most accurate indicator of future values.

Exchange rate models have been updated in an attempt to out-predict the random walk model; however, the latter still holds as the predominating science in understanding fluctuations in exchange rates. In all, we shouldn’t expect the prospective June rate hike to cause short term dollar appreciation and emerging-market economy distress. For the time being developing economies are out of harm’s way from the Fed.

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