Financial markets in the emerging world reacted negatively to the outcome of last week’s monetary policy meeting in the US. But the Federal Reserve’s (Fed) shift towards average inflation targeting should eventually lend some support to the performance of assets.

By allowing the US economy to “run hot”, with unemployment falling below the level consistent with stable inflation, there should be increased demand for exports from emerging markets (EM) in Asia, along with neighbouring Mexico. Meanwhile, a prolonged period of very low interest rates in the US is likely to cause investors to look further afield in a hunt for yield, weakening the US dollar as outflows increase. This has historically been a fertile environment for the performance of EM assets.

In the longer term, however, there is a risk that increased capital flows to EM could cause imbalances to build. The counterpart to an influx of relatively short-term capital inflows is likely to be larger current account deficits in those countries that have loose macroeconomic policy, and weak domestic supply potential.

These markets would be vulnerable to a sudden stop in capital flows, similar to the crisis in the “fragile five” that struck after the 2013 taper tantrum. What’s more, countries could also gorge on easy money and sow the seeds for future debt problems.

Why allowing the US economy to “run hot” could boost demand for EM exports

Emerging market (EM) bonds, currencies and equities all suffered losses last week after the conclusion of the September meeting of the Federal Open Market Committee (FOMC). Perhaps because investors were anticipating that policymakers would pump even more stimulus into the system.

• Read more: What the Fed's new target means for inflation

However, in our view, the key takeaway from the meeting was the incorporation of the new average inflation targeting (AIT) framework into the Fed’s forecasts. This suggests that monetary policy in the US will remain looser than it otherwise would have been for a longer period of time. We recently reviewed the detail behind the change in the approach. There a couple of reasons to think that AIT could have a significant impact on EM.

The first is that AIT may lead to stronger demand for EM exports. The implication of AIT is that policymakers will actively seek to generate excess demand in order to create higher inflation. The counterpart to this will be stronger economic growth, which in turn would increase US demand for imports from its trading partners many of which are in the emerging world.

All EM would benefit from stronger US demand. But as chart 1 shows, it would be a particular boost for markets in Asia and Mexico that produce a significant portion of the value-added in goods that are imported by the US.

Capital flows to EM are likely to increase as investors hunt for yield

The second, perhaps more important, reason is that persistently low interest rates are likely to drive a hunt for yield into EM. The mechanics of AIT are still vague, but a key consequence is likely to be that the Fed will keep monetary policy very loose for a long time. That ought to anchor the yield of Treasury bonds at low levels for a prolonged period of time – and even negative in real terms.

Structurally lower “risk-free” rates are likely to force investors to cast their nets wider as they hunt for yield. Short-term capital flows to EM have historically accelerated as Treasury yields have declined. This is illustrated in chart 2, with short term flows the sum of portfolio flows into bond and equity markets along with “other” flows which tend to be mainly banking flows. And those inflows are likely to continue if yields remain at rock bottom levels for an extended period of time. It is these increases in capital and trade flows that cause the dollar to weaken, which is often cited as a positive signal for returns from EM.

All of this is likely to ensure that the performance of EM assets will be better than it otherwise would have been. After all, stronger activity ought to have at least some positive impact on corporate earnings and public sector balance sheets. A prolonged period of lower risk-free rates is likely to see investors scale back the rates of return required from EM assets; especially as valuations in developed markets become even more stretched. And with more investors chasing EM assets as inflows increase, the net result is likely to be higher asset prices.

Could AIT sow the seeds for future EM crises?

In the longer term, however, there is a risk that increased capital flows to EM as a result of AIT could cause imbalances to build that would ultimately sow the seeds of future crises.

The counterpart to an influx of capital inflows is likely to be larger current account deficits in those countries that have loose macroeconomic policy and weak domestic supply potential. Markets may eventually fear that the Fed will tighten policy aggressively in order to prevent high inflation expectations from becoming ingrained. In this scenario, economies using short-term financing to run large current account deficits would be vulnerable to a sudden stop in capital inflows. This has so often been the trigger for EM crises.

A recent example was during the post-global financial crisis (GFC) period when rapid inflows allowed many EM economies to run large current account deficits funded by short-term capital. When Ben Bernanke, Fed Chair at the time, sparked the taper tantrum in May 2013 and investors headed for the exits, unsustainable external positions in the “fragile five” came under pressure. This led to large currency depreciation that forced central banks to raise interest rates even in the face of weaker growth.

Similarly, as chart 3 shows, a sustained decline in real Treasury yields (TIPS) into negative territory drove a hunt for yield that increasingly leaked into relatively poor quality EM assets such a non-investment grade (IG) bonds. That caused spreads to tighten significantly, before the taper tantrum sparked an abrupt sell-off. This is not an immediate threat given that spreads are still relatively wide, but a risk worth monitoring in the next few years.

Finally, past inflows of easy money to EM have invariably resulted in some issuers overstretching themselves and sowing the seeds for future defaults. The most recent example comes from Argentina, where the government was able to issue an enormous amount of foreign currency debt in 2017 that ultimately resulted in the default three years later, and the recent sovereign restructuring.

The upshot is that while AIT may result in a rising tide of liquidity that will lift all EM, investors need to be wary of becoming submerged.