What a US rate rise means for the world economy
Markets expect the Federal Reserve to increase the cost of borrowing in America tomorrow for the first time since 2006. But some economists are anxious about the consequences.
Ben Chu examines the possible implications of an expected move by the Federal Reserve tomorrow
America’s central bank, the Federal Reserve, is almost universally expected by the financial markets to put up interest rates for the world’s largest economy tomorrow, to head off the risk of a burst of inflation in the coming year.
The increase has a deep economic significance because it will be the first time the Fed has put up rates since 2006. On the face of it, a rise would signal that the US economy has returned to something like normality; that it has finally recovered from the global financial crisis. But there is also profound uncertainty about how the economy will cope with this monetary tightening after such a long period of rock-bottom 0.25 per cent rates. Here we look at some of the possible impacts of the Fed’s decision tomorrow evening.
Impact on US households and employment
If rates do rise the cost of taking out a new mortgage in the US will become more expensive. The cost of unsecured consumer credit will also increase. But few expect a 0.25 percentage point increase in the Federal Funds rate to 0.5 per cent rate to prompt a destructive collapse in household spending. For one thing, most Americans have fixedrate mortgages rather than variable, meaning the impact will not be immediate.
A greater fear than a return to recession is that a rate hike will slow growth unnecessarily. “It is entirely possible that in trying to slay the inflation bogey by raising rates the Federal Reserve merely crimps economic growth,” says Peter Toogood of City Financial.
The headline US unemployment rate is now just 5 per cent, down from a peak of 10 per cent in 2009. But the participation rate has plummeted from 66 per cent before the financial crisis to about 62 per cent today. And wage growth remains tepid. Some economists say this implies there is still considerable slack in the labour market and that tightening monetary policy now will needlessly waste resources. The Nobel economics laureate Paul Krugman argues: “The clamour for higher rates has nothing to do with the public interest.”
Another fear among economists is that the “neutral” rate of interest is now lower than it was before the financial crisis, for demographic and structural economic reasons, meaning rates will not climb back to their old average of 4-5 per cent. This means that if and when another recession hits the US economy it will be harder for the Fed to stimulate growth by cutting rates because they will still be relatively low. This “asymmetry of risk”, these economists argue, makes the case for raising rates only when inflation has become an unequivocal and glaring threat.
Impact on US companies
A rate rise will mean a higher cost of borrowing for companies. Yet this is unlikely to have a direct impact on big companies’ investment plans. These firms are so cash rich they don’t actually need to borrow to invest. Indeed, higher rates could make them more inclined to hang on to their cash because they will earn higher returns on their bloated bank balances. And if the rate rise impedes consumer demand growth it could reduce their willingness to spend to expand their production capacity. Further, if rising interest rates cause financial market turbulence, that could also undermine their willingness to invest.
A US rate rise will push up the value of the dollar against other currencies as investors seek better returns, making US exports less competitive in global markets and reducing corporate profit growth. That too could result in lower investment than otherwise – although the dollar has already been rising fast this year as expectations of a rate rise have piled up.
Impact on bonds and shares
Declines in interest rates generally push up the value of government debt and corporate bonds. The assumption is that a rise in rates will have the opposite effect.
A $788m (£520m) investment fund run by Third Avenue Management that invested in high-yield (and so higher-risk) corporate debt had to wind itself down last week due to losses and redemptions. This fund was particularly exposed because of the risk and illiquidity of its portfolio. Yet there could well be others that get into trouble too. The activist investor Carl Icahn has suggested there is a “meltdown” coming for highyield debt. The question is whether these failures could be sufficient to set off a general financial panic.
The former US Treasury Secretary Larry Summers says: “At this moment of fragility, raising rates risks tipping some part of the financial system into crisis, with unpredictable and dangerous results.”
Share prices also tend to benefit from monetary stimulus – but the S&P 500 is already trading lower than at the start of the year, implying the impact of the rate rise might already be priced in.
Impact on rest of the world
The dollar is the world’s number one reserve currency. The bulk of crossborder trade and investment is denominated in dollars. Emerging market states hold most of their foreign exchange reserves in dollar debt. They also often borrow in dollars. All this means that what the Fed does has a profound impact on the global financial system.
During the 2013 “taper tantrum”, when the Fed announced that it would be reducing the pace of its asset purchases, traders yanked moneyout of emergingmarket economies in order to plough it back into higher-yielding US assets. This rapid dollar flight caused major problems for states such as India, Mexico, Turkey and Indonesia.
Those countries now seem better prepared for US monetary tightening. “Fundamentals have improved in several large emerging market economies since the taper tantrum,” say analysts from Bank of America. But there is still a non-negligible risk that the Fed could set off an earthquake elsewhere, pushing the global economy back into recession. Some stress that it would not take much to tip the scales. The Chinese economy, still the world’s big motor of economic growth, is slowing down alarmingly.And the world economy is already set for its slowest growth since the financial crisis in 2015.
At this moment, raising rates risks tipping some parts of the financial system into crisis