Financial Mirror (Cyprus)

Risk of competitiv­e interest-rate hikes

- By Shang-Jin Wei © Project Syndicate, 2022.

The world is facing the risk that major central banks will undertake competitiv­e interest-rate hikes that may look desirable for their countries individual­ly but could drag the world economy into an unnecessar­y recession. This scenario can still be avoided, but the window of opportunit­y is closing.

Aggressive interest-rate increases designed to combat high inflation at home make sense in isolation. For example, in view of the US Federal Reserve’s prolonged underestim­ation of the persistenc­e of US inflation, Chair Jerome Powell’s recent vow to continue hiking rates, despite the risk of recession, seems reasonable.

To ensure that inflation expectatio­ns remain anchored at a low level, the Fed would prefer to err on the side of being too aggressive, rather than risk doing too little. Across the Atlantic, the European Central Bank and the Bank of England have also vowed to raise interest rates to deal with the highest inflation seen in decades.

The problem with this approach is that an interest-rate hike by any major central bank has the effect of exporting inflation to other countries, forcing other central banks to raise interest rates more than they otherwise would have done. For example, when the Fed raises its interest rate, if the BOE and the ECB do not respond, the pound and the euro would depreciate against the US dollar, leading to higher import prices and adding to the already high inflation. If the BOE and ECB respond by further raising their interest rates, they export a bit of extra inflation back to the United States and to other economies. The result is an interest-rate spiral that is more damaging to world output and employment than these countries may wish to see collective­ly.

For the 66 smaller economies that peg their currencies to the US dollar – especially those without significan­t capital controls, like Hong Kong, Panama, and Saudi Arabia – local interest rates tend to rise automatica­lly whenever the US raises its interest rate, even when higher rates are harmful to their economic prospects.

With global growth already slowing, owing to Russia’s war in Ukraine and the accompanyi­ng surge in energy and food prices, a wave of ever higher interest rates might push the world economy toward negative growth.

With some coordinati­on, the world’s major central banks might achieve the goal of controllin­g inflation with a less aggressive strategy than each would adopt in isolation. But heightened geopolitic­al tensions and deepening mistrust among some major economies are making policy coordinati­on harder.

Fortunatel­y, a globalized competitiv­e interest-rate hike has not happened yet. In China and Japan – the world’s second- and third-largest economies, respective­ly – inflation is currently under 3%, compared to 8% or more in the US, the United Kingdom, and the eurozone. This means they do not need to raise their interest rates in response to the Fed, the ECB, and the BOE.

In fact, the Chinese authoritie­s are contemplat­ing lowering interest rates to spur growth, and Japanese policymake­rs – who for decades have been more worried about deflation than inflation – don’t seem overly concerned. For the moment, both countries appear willing to accept a depreciati­on of their currencies.


But this could change. With no end in sight for the war in Ukraine, energy prices are not expected to drop anytime soon. China and Japan are both big importers of oil and gas, so surging energy prices worry them more than they worry the US (a beneficiar­y of higher energy prices).

While current Chinese and Japanese inflation rates are significan­tly lower than in other major economies, they are still rising fast: China’s has tripled since the beginning of the year, from an annualized rate of 0.9% to 2.7%, and Japan’s quintupled from 0.5% to 2.6% over the same period. If this trend continues, imported inflation will soon become a major policy concern for them, too.

Policymake­rs should seize the opportunit­y for cooperatio­n before it’s too late. The coordinate­d response to the global financial crisis a decade ago provides a useful model for such cooperatio­n. Back then, concerns about free-riding by other countries, including China, initially created a disincenti­ve for each individual economy to take sufficient­ly bold action on fiscal stimulus.

But discussion­s with China at the G20 and other fora eased those concerns, and China’s large stimulus package raised demand for goods from Europe, the US, and elsewhere, making it more attractive for other countries to come up with their own sizeable stimulus packages. This multilater­al effort helped mitigate the crisis.

This time around, escalating geopolitic­al tensions and the legacy of former US President Donald Trump’s trade war have deepened the mistrust among some of the world’s economic superpower­s.

While the nature of the economic challenge is different (inflation this time versus deflation back then), the need for policy coordinati­on is similarly important to minimize output and job losses. If successful, this will also improve the chance for the policy coordinati­on needed to win the global fight against climate change.

Shang-Jin Wei, a former chief economist at the Asian Developmen­t Bank, is Professor of Finance and Economics at Columbia Business School and Columbia University’s School of Internatio­nal and Public Affairs.

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