America’s interest rate must not work against the world’s interest
A clear squeeze of other economies and dubious gains for the US should make the Fed rethink its tightening of monetary policy
Last month, this column had argued that monetary policy in the US, which has raised interest rates sharply over six months, is not likely to curb inflation but is surely risking a recession. Since then, consumer price inflation has persisted at 8.2% in end-September 2022, while the US Fed has announced a further hike of 0.75% last week, raising the benchmark rate to 3.75-4% in early- November 2022, on track for the projected 4.5% by end-2022. Two obvious questions arise. How long does the Fed think it will take to slow inflation down? How much can the Fed raise interest rates for consumer price inflation to reach the targeted level of 2% per annum? There is a less obvious question that is just as important, perhaps more worrisome. What does this mean in terms of unintended consequences for the world economy?
The US, which is home to 4% of the world population but accounts for 22% of world GDP, is the world’s largest economy. However, its influence on the world economy, through global trade, investment and finance, is disproportionately large. The essential underlying reason is that the US dollar is the only national currency that is the equivalent of international money, as a unit of account, medium of exchange and a store of value. Estimates suggest that more than 50% of international transactions and international debt are denominated in US dollars, while the proportion of world trade conducted in US dollars is even higher.
Thus, a stronger dollar is the immediate outcome of higher interest rates in the US, which attract finance capital from everywhere, while risk averse investors are induced to move capital out of elsewhere. In a world of uncertainty, the dollar is perceived as secure and stable, so that the worse things get, the more people buy dollars. During January-September 2022, the US dollar appreciated by almost 18% vis-a-vis six major currencies to reach its highest parity in decades. The turbulence in world financial markets, the worst since 2008, is also an immediate consequence of higher interest rates in the US, as share prices have tumbled and bond portfolios have taken a beating, while banks and pension funds, which lapped up risky investments when interest rates were near-zero, are suddenly most vulnerable. Yet, the unintended consequences of the Fed’s tightening monetary stance have been far more devastating for the world outside the US, not only for emerging or developing economies, but also for industrialized economies.
In the past, industrialized countries have coped with the strength of the dollar. This time around, however, much greater stress is discernible. During January-September 2022, the US dollar has appreciated sharply, for example, by as much as 20%-30% against the euro, British pound, Japanese yen, and Korean won. Inflation has surged to double-digit levels in the EU and Britain. Their central banks have not been able to keep pace with the Fed on interest rates, because their economies, already in an economic slowdown with high unemployment levels, do not have the strength or resilience. And, as bond yields surge, the EU’s most indebted economies—Greece, Ireland, Italy, Portugal and Spain—appear almost as fragile as they did in their sovereign debt crises circa 2009-2010.
For emerging economies in Asia and Latin America, the immediate consequence has been large outflows of portfolio investment, driven by higher interest rates in the US and concerns about exchange rate risk in host countries. This has mounted pressure on their currencies. But the US dollar has appreciated significantly less than among industrialized countries, in the range 5%-15%, essentially because central banks (for example, in Brazil, China, India, Indonesia, Mexico, Singapore and Thailand) have intervened in financial markets to support their currencies, and have also raised their benchmark interest rates. The latter is bound to stifle investment and dampen consumption, leading to a contraction in aggregate demand, causing a downturn and risking a recession.
For other countries in the developing world, the situation is distinctly worse. Their currencies have depreciated far more. Commodity prices have dropped, squeezing export earnings. But the costs of essential imports, not only wheat, crude oil and fertilizers (where prices are already high because of the Russia-Ukraine war), but also consumer necessities such as bread, sugar, coffee or medicines, have risen sharply. For countries borrowing abroad, which also ran up further debts to cope with the pandemic, the domestic resource cost of servicing their debt denominated in dollars has risen steeply. The poorest countries are clearly the most vulnerable.
Obviously, central banks everywhere must rethink, indeed question, their orthodox belief systems that raising interest rates is the only way to fight inflation because, at present, rapidly rising consumer prices are being driven by supply-demand imbalances—not excess liquidity—and, for most, by exogenous factors in the world economy beyond their control, so that monetary tightening can only push them into recession.
The Fed also needs to recognize that, ironically enough, the appreciation of the dollar, which makes imports of consumer goods cheaper for the US, might end up moderating its consumer price inflation. In effect, it is exporting inflation, mitigating some of its own, while accentuating it around the world. This benefit is illusory. The US cannot be an island of prosperity in an integrated world economy if the world outside slips into recession.
Deepak Nayyar is emeritus professor of economics, Jawaharlal Nehru University.
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First Published:10 Nov 2022, 10:50 PM IST
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