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The International Monetary Fund warned that a potential surprise tightening by the US Federal Reserve could spur an increase in interest rates and capital outflows from emerging markets, underlining the need for clear central bank communication.

Rising market interest rates in the US so far have been driven by positive news on economic prospects and Covid-19 vaccines, which tends to boost portfolio inflows and lower spreads on US dollar-denominated debt for most emerging markets, the IMF said Monday in an analytical chapter of its World Economic Outlook.

The Fed has said it will maintain near-zero interest rates until the U.S. economy hits maximum employment and inflation is on track to exceed 2% for some time. But if central banks in advanced economies were to suddenly signal greater concern for inflation risks, the world could see a surprise tightening of financial conditions similar to the 2013 “taper tantrum," IMF economists Philipp Engler, Roberto Piazza and Galen Sher wrote.

“Monetary policy surprises," as measured by the increase in interest rates on days of regularly scheduled Fed decisions, found that for each 1 percentage-point rise in U.S. interest rates, long-term rates climb by a third of a point in the average emerging market, the authors said in an accompanying blog post. The increase is two-thirds of a point in emerging markets with lower, speculative-grade credit ratings, the IMF said.

To avoid triggering a deterioration in investor sentiment about emerging markets, advanced economy central banks can give clear, transparent communications about future monetary policy under different scenarios, the IMF said. The fund cited the Fed’s guidance about pre-conditions for a rate increase as an example. The IMF said that further Fed guidance on possible future scenarios would be useful.

The IMF, which on Tuesday will release the principal forecasting section of the World Economic Outlook, last week cautioned that the global economy is at risk of being scarred by the pandemic and called on policy makers to limit the pain. The fund and the World Bank begin their week-long virtual spring meetings on Monday.

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