The US Federal Reserve is almost certain to start raising interest rates when the policy-setting Federal Open Markets Committee meets on Dec. 16. How worried should businesses, investors, and policymakers around the world be about the end of near-zero interest rates and the start of the first monetary tightening cycle since 2004 to 2008?
Fed Chair Janet Yellen has repeatedly said that the impending sequence of rate hikes would be much slower than previous monetary cycles and predicted that it would end at a lower peak level. While central bankers cannot always be trusted when they make such promises, since their jobs often require them deliberately to mislead investors, there are good reasons to believe that the Fed’s commitment to “lower for longer” interest rates is sincere.
The Fed’s overriding objective is to lift inflation in the US and ensure that it remains above 2 percent. To do this, Yellen would have to keep interest rates very low, even after inflation starts rising, just as her predecessor Paul Volcker had to keep interest rates in the 1980s very high, even after inflation started falling.
This policy reversal follows logically from the inversion of central banks’ objectives, both in the US and around the world, since the 2008 crisis.
In the 1980s, Volcker’s historic responsibility was to reduce inflation and prevent it from ever rising again to dangerously high levels. Today, Yellen’s historic responsibility is to increase inflation and prevent it from ever falling again to dangerously low levels.
Under these conditions, the direct economic effects of the Fed’s move should be minimal. It is hard to imagine many businesses, consumers, or homeowners changing their behavior because of a quarter-point change in short-term interest rates, especially if long-term rates hardly move.
Even assuming that interest rates reach 1 to 1.5 percent by the end of next year, they would still be very low by historic standards, both in absolute terms and relative to inflation.
The media and official publications from the IMF and other institutions have raised dire warnings about the impact of the Fed’s first move on financial markets and other economies. Many Asian and Latin America countries, in particular, are considered vulnerable to a reversal of the capital inflows from which they benefited when US interest rates were at rock-bottom levels.
However, as an empirical matter, these fears are hard to understand.
The imminent US rate hike is perhaps the most predictable, and predicted, event in economic history. Nobody would be caught unawares if the Fed acts next month, as many investors were in February 1994 and June 2004, the only previous occasions remotely comparable to the current one. And even in those cases, stock markets barely reacted to the Fed tightening, while bond-market volatility proved short-lived.
However, what about currencies? The US dollar is almost universally expected to appreciate when US interest rates start rising, especially because the EU and Japan are to continue easing monetary conditions for many months, even years.
This fear of a stronger US dollar is the real reason for concern, bordering on panic, in many emerging economies and at the IMF. A significant strengthening of the US dollar would indeed cause serious problems for emerging economies where businesses and governments have taken on large US dollar-denominated debts and currency devaluation threatens to spin out of control.
Fortunately, the market consensus concerning the US dollar’s inevitable rise as US interest rates increase is almost certainly wrong, for three reasons.
First, the divergence of monetary policies between the US and other major economies is already universally understood and expected. Thus, the interest-rate differential, like the US rate hike itself, should already be priced into currency values.
Moreover, monetary policy is not the only determinant of exchange rates. Trade deficits and surpluses also matter, as do stock-market and property valuations, the cyclical outlook for corporate profits, and positive or negative surprises for economic growth and inflation.
On most of these grounds, the US dollar has been the world’s most attractive currency since 2009; but as economic recovery spreads from the US to Japan and Europe, the tables are starting to turn.
Finally, the widely assumed correlation between monetary policy and currency values does not stand up to empirical examination. In some cases, currencies move in the same direction as monetary policy — for example, when the yen dropped in response to the Bank of Japan’s 2013 quantitative easing.
However, in other cases the opposite happens, for example when the euro and the pound both strengthened after their central banks began quantitative easing.
For the US, the evidence has been very mixed. Looking at the monetary tightening that began in February 1994 and June 2004, the dollar strengthened substantially in both cases before the first rate hike, but then weakened by around 8 percent, as gauged by the Fed’s dollar index, in the subsequent six months. Over the next two to three years, the dollar index remained consistently below its level on the day of the first rate hike.
Therefore, for currency traders the last two cycles of Fed tightening turned out to be classic examples of “buy on the rumor; sell on the news.”
Of course, past performance is no guarantee of future results and two cases do not constitute a statistically significant sample.
Just because the US dollar weakened twice during the last two periods of Fed tightening does not prove that the same thing would happen again.
However, it does mean that a rise in the US dollar is not automatic or inevitable if the Fed raises interest rates next month.
The globally disruptive effects of US monetary tightening — a rapidly rising US dollar, capital outflows from emerging markets, financial distress for international dollar borrowers and chaotic currency devaluations in Asia and Latin America — might loom less large in next year’s economic outlook than in a rear-view glimpse of this year.
Anatole Kaletsky, a former columnist for the Times of London, the International New York Times and the Financial Times, is chief economist and co-chairman of Gavekal Dragonomics.
Copyright: Project Syndicate
Could Asia be on the verge of a new wave of nuclear proliferation? A look back at the early history of the North Atlantic Treaty Organization (NATO), which recently celebrated its 75th anniversary, illuminates some reasons for concern in the Indo-Pacific today. US Secretary of Defense Lloyd Austin recently described NATO as “the most powerful and successful alliance in history,” but the organization’s early years were not without challenges. At its inception, the signing of the North Atlantic Treaty marked a sea change in American strategic thinking. The United States had been intent on withdrawing from Europe in the years following
My wife and I spent the week in the interior of Taiwan where Shuyuan spent her childhood. In that town there is a street that functions as an open farmer’s market. Walk along that street, as Shuyuan did yesterday, and it is next to impossible to come home empty-handed. Some mangoes that looked vaguely like others we had seen around here ended up on our table. Shuyuan told how she had bought them from a little old farmer woman from the countryside who said the mangoes were from a very old tree she had on her property. The big surprise
The issue of China’s overcapacity has drawn greater global attention recently, with US Secretary of the Treasury Janet Yellen urging Beijing to address its excess production in key industries during her visit to China last week. Meanwhile in Brussels, European Commission President Ursula von der Leyen last week said that Europe must have a tough talk with China on its perceived overcapacity and unfair trade practices. The remarks by Yellen and Von der Leyen come as China’s economy is undergoing a painful transition. Beijing is trying to steer the world’s second-largest economy out of a COVID-19 slump, the property crisis and
As former president Ma Ying-jeou (馬英九) wrapped up his visit to the People’s Republic of China, he received his share of attention. Certainly, the trip must be seen within the full context of Ma’s life, that is, his eight-year presidency, the Sunflower movement and his failed Economic Cooperation Framework Agreement, as well as his eight years as Taipei mayor with its posturing, accusations of money laundering, and ups and downs. Through all that, basic questions stand out: “What drives Ma? What is his end game?” Having observed and commented on Ma for decades, it is all ironically reminiscent of former US president Harry