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

Source: Board of Governors of the Federal Reserve System. Found at: fred.stlouisfed.org/series/DTWEXBGS

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.

For the full version of this article and to view sources, please visit our website.

Never miss an insight

If you're not an existing Livewire subscriber you can sign up to get free access to investment ideas and strategies from Australia's leading investors.

And you can follow my profile to stay up to date with other wires as they're published – don't forget to give them a “like”.

........
Livewire gives readers access to information and educational content provided by financial services professionals and companies (“Livewire Contributors”). Livewire does not operate under an Australian financial services licence and relies on the exemption available under section 911A(2)(eb) of the Corporations Act 2001 (Cth) in respect of any advice given. Any advice on this site is general in nature and does not take into consideration your objectives, financial situation or needs. Before making a decision please consider these and any relevant Product Disclosure Statement. Livewire has commercial relationships with some Livewire Contributors.

Michael Collins
Investment Specialist
Magellan

Michael Collins is an investment specialist at Magellan. Michael has worked as an investment specialist/commentator for money managers in Australia since 2000. Before that, Michael worked for 14 years as a business journalist for mainstream...

I would like to

Only to be used for sending genuine email enquiries to the Contributor. Livewire Markets Pty Ltd reserves its right to take any legal or other appropriate action in relation to misuse of this service.

Personal Information Collection Statement
Your personal information will be passed to the Contributor and/or its authorised service provider to assist the Contributor to contact you about your investment enquiry. They are required not to use your information for any other purpose. Our privacy policy explains how we store personal information and how you may access, correct or complain about the handling of personal information.