Quantifying the Fed’s Impact on Capital Flows to EMs

December 04, 2013

We present evidence suggesting that the Fed’s impact on portfolio inflows to emerging markets may be more nuanced than widely assumed. We estimate a simple econometric model indicating that the recent retrenchment episode was primarily driven by a shift in market expectations towards an earlier tightening of Fed policy, rather than a markdown in expectations about EM economic performance. Looking ahead, our model suggests that the Fed’s impact on EM portfolio inflows depends on the pace of Fed exit relative to market expectations and the volatility of market expectations over time. A slower than expected Fed exit and stable market expectations would tend to boost portfolio inflows, while a more rapid exit than anticipated could result in renewed retrenchment, particularly if market expectations were to fluctuate widely.