JACKSON HOLE, Wyo. — The Federal Reserve and other major central banks need to be more mindful of the "spillover" effects of their "unconventional" monetary policies, Bank of Mexico Governor Augustin Carstens said Friday.

Carstens, speaking at the Kansas City Federal Reserve Bank's annual symposium, said emerging market nations like his are facing major challenges as the Fed contemplates reducing its large-scale asset purchases.

As expectations of Fed "tapering" drive up bond yields and hurt asset prices worldwide, he said emerging market countries are experiencing large "reversal" of previous capital inflows and increased volatility in their financial markets. This is hurting their economies, he said.

To cope with these problems, Carstens said emerging markets must resort to "macro-prudential" measures, exchange rate management and various internal reforms, but said there is a limit to what they can do to resist volatile capital outflows.

So Carstens said the Fed and other major central banks need to "implement a more predictable exit" and use "better communication, speaking with one voice."

When it comes to "tapering," the Fed needs to "time it well," he added.

"Advanced country central banks should mind the spillover effects of their actions," Carstens went on. "Otherwise the crisis will be reactivated with new actors."

He added that it would be "desirable to have monetary policy coordination" because "to have central banks go in different directions at this time can become a source of instability."

When the Fed slashed the federal funds rate to zero and resorted to heavy bond buying to lower long-term interest rates, Mexico and other developing countries experienced large capital inflows in search of higher yields. But since the Fed began hinting at less bond buying, yields have been rising and these flows have gone in the opposite direction.

Carstens said this "reversal could become much larger in the future," and he added, "volatile flows have been very pernicious."

"The outflows we've recently seen are far larger than what we saw in the past, even at the time of the outset of the crisis," he said.

The unconventional monetary policies of the U.S. and other countries are not entirely responsible for this volatility, he conceded, but it is "not completely innocent," he said.

Another problem, according to the chief Mexican central banker, is that talk of tapering has "basically created a one-sided market in many instruments." And "this one-sided market has enhanced the volatility of flows."

Carstens said that in emerging market countries with floating exchange rate regimes, "the exchange rate is a very important component of the monetary policy transmission mechanism."

And so "having enhanced volatility of exchange rates makes the implementation of monetary policy very challenging."

Carstens also deplored the fact that "the very low interest rate environment in advanced countries, together with friction in financial markets have generated persistent opportunities for uncovered interest rate arbitrage" and "has opened opportunities for market participants to do massive carry trade strategies."

"Large capital inflows deepen mispricing in local markets and increase danger of reversals," he added.

Market News International is a real-time global news service for fixed-income and foreign exchange market professionals. See www.marketnews.com.

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