Higher US interest rates test the world

New York’s Plaza Hotel, in financial circles, is best known for when the finance ministers of France, Japan, the UK, the US and West Germany gathered in 1985 to suspend the free-float of the US dollar.

The problem the ministers sought to solve was that the US dollar had soared 44% since 1980 because US interest rates had jumped over that time. The world was worried the subsequent widening of the US trade deficit could prompt Washington to restrict imports. Under the Plaza Accord, the G-5 agreed to – and did – lower the US dollar over the following two years.

Another Plaza Accord might be needed in coming times. Once again, rising US interest rates are boosting the US dollar to heights that trouble the world. Against the ‘real broad dollar index’, the US currency has surged 10% over the past year to its highest since this index was compiled in 2006. US interest rates are rising because the Federal Reserve needs to smother inflation that has reached four-decade highs.

Nominal broad US dollar index since 2006

Higher interest rates in the world’s largest economy always present challenges for the world. Today’s trials wrought by higher US rates, however, could be more troubling than usual because the pandemic and Ukraine war are magnifying the standard threats posed by higher US interest rates while minimising the usual benefits. Three difficulties stand out, starting with the higher greenback.

While a stronger US dollar eases US inflationary pressures via cheaper imports, the flip side, however, is the rest of the world confronts an inflationary shock in three ways: 

1. US exports cost more in other currencies. 
2. Trade priced in US dollars between non-US parties becomes more expensive in other currencies. 
3. The inflation threat is that today’s strong US dollar is unusually coinciding with higher oil prices due to the Ukraine war, which magnifies the increase in oil prices in other currencies.

To counter this inflation threat, central banks the world over are unexpectedly boosting key rates in bigger steps to support their currencies in what has been dubbed a ‘reverse currency war’. The futility is that all countries can’t push their currencies in the same direction at the same time.

The Eurozone is especially vulnerable to imported inflation – the euro has slid to a 20-year low (below parity) against the US dollar. Eurozone inflation at a record high has belatedly forced the European Central Bank to end eight years of negative rates.

While the ECB’s delay in raising rates has undermined the euro, the lag and tumbling currency are more because the eurozone’s economic fundamentals are so weak. The ECB is worried that inflation will drive yields on the sovereign debt of indebted euro members to levels that trigger another financial crisis and possible exits from the common currency.

The second challenge of higher US rates is they hamper the US economy. US GDP, which is about 70% consumer spending, contracted over the first six months of 2022. The immediate outlook seems problematic because the fiscal stimulus tied to the pandemic and supply disruptions have boosted inflation to levels that trouble consumers. A weak US economy means the high US dollar is not offering its usual boost to world exports – as it did in the first half of the 1980s.

The third challenge of higher US interest rates is they bludgeon emerging countries, especially those that have borrowed in US currency or have currencies linked to the greenback. The world’s 40 most at-risk countries on IMF calculations have been weakened by the pandemic and face a cost-of-living crisis resulting from the Ukraine war. The fact that emerging countries are overwhelmingly borrowing in local currencies is failing to insulate them from higher US interest rates and a stronger US dollar. A Bank of International Settlements paper in July warns how the currency risk has only shifted to creditors who invest on a US-dollar basis. Thus, capital is still fleeing emerging countries.

The Institute of International Finance estimates international investors yanked US$38 billion from emerging markets in the five months to July. Emerging-country currencies tumbled accordingly. The linked inflation threat has forced central banks to raise rates to support currencies. Concerns are rising that economic turmoil could lead to political instability.

Central banks are far from winning their battles against inflation. The accelerated loop triggered by a pandemic-and-war-distorted world whereby higher US rates force other countries to raise rates could run for a while yet. The best hope for the world is that something – ideally, a decline in US inflation, but even a US recession – dampens US interest rates and averts financial upheavals in the eurozone and emerging countries.

To be sure, US inflation might have already peaked and the Fed might slow rate increases. But the crest of inflation could matter less than the stubbornness of inflation. If US inflation only slows gradually, US interest rates will stay elevated.

The pity is that in a world of floating exchange rates central banks outside the US, for all their domestic political independence, are tied to a Fed that misjudged inflation. There’s no solution, let alone an international accord, shaping to alleviate the dangers.

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