What a Fed Rate Hike Means for Cross-Border Flows

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A rate hike by the Federal Reserve could spark trillions of dollars worth of cross-border capital flows. Photo: Tischenko Irina / Shutterstock

By most accounts, the Federal Reserve will likely raise rates for the first time in nearly a decade at its next meeting later this month. The CME Group’s FedWatch tool puts the chance of a rate hike in December at 78 percent.

This impending rate hike is a big deal because it comes after years of near-zero interest rates following the worst financial crisis in nearly a century. Since then the Fed has embarked on an unprecedented central banking journey known as quantitative easing in order to jumpstart the U.S. economy. As such, even the mechanics by which the Fed raises rates when the time comes will be historic, uncharted territory.

But aside from all the cultural significance and technical complexity, the rate hike’s impact on cross-border capital flows is relatively straightforward—where we see capital outflows from emerging markets and Europe accelerate as money floods into the U.S.

After the the Great Recession, with rates at record lows and the Fed Chair Ben Bernanke beginning his bond-buying program, hot money fled the U.S. in search of higher returns. Much of that capital ended up in emerging markets. According to the IMF, $4.5 trillion of gross capital flowed into developing economies between 2009 and 2013, which represents half of all capital flows during that period.

The recipients of those capital flows like Malaysia are now experiencing slow downs and with an expected Fed rate hike in the near future, all that capital will likely flow the other way back into the U.S. And those flows could be compounded by weakened, over-leveraged emerging economies and perceived economic strength and stability in the U.S. Those outbound flows would then further weaken those developing economies, creating a debilitating cycle.

“Once the Fed moves, investors will move money back into the U.S., depriving emerging markets of capital,” the WSJ reports, adding that this will then further “weaken their currencies and send inflation higher.”

Then there’s Europe, which has experienced deflation and double-dip recessions forcing the ECB to start up another round of quantitative easing, reports The Economist, prompting capital to flow stateside from the Old Continent as well.