Why is the FED’s monetary policy important for the global economy?

Last December, the Federal Reserve of the United States announced its decision to raise the official interest rate by 25 basis points for the second time in almost a decade. With the US Central Bank expected to repeat this action another two or three times in 2017, this progressive tightening marks the end of an era of accommodating monetary policy and will be of tremendous importance in analysis of the global economic drivers over the coming year. So why is this so important for the rest of the world and what can we expect for the year ahead?

To lay some groundwork, let’s recall that, constitutionally, the FED has two mandates. First, to ensure price stability, consisting of maintaining an inflation target of 2%. Second, to support growth and employment. To succeed in these missions, the Federal Open Market Committee (FOMC) uses powerful monetary tools. The most commonly known tool is the FED’s ability to set the Federal Funds Rate, which is the average interest rate that determines how much it costs for financial institutions to lend to one another. The interest rate set by the Central Bank is transferred to the real economy by intermediaries – financial institutions – that in turn lend to governments for public expenditures, companies for investments and households for consumption. The underlying principle is simple: when the economy is overheating, Central Banks increase their interest rates to dissuade agents from borrowing loads of money. On the contrary, when the economy is slowing down, interest rates are cut to encourage borrowing and stimulate the drivers of growth: investments, consumption and government expenditure.

Following the financial crisis of 2007 that affected the global economy and plunged the world into the Great Recession, Central Banks, rather than governments, have taken on much of the responsibility for turning the economy around. The FED, together with the Bank of England and the European Central Bank, have led with what we call a Zero Interest Rate Policy, to prevent the economy from collapsing even more. This basically means free money for everyone, as the cost of taking out a loan reaches near zero levels, but it also set the tone for a decade of very low returns on investments, driving investors to constantly seek for alternative and possibly riskier ways of making profits.

This shift of power from governments to Central Banks has made monetary policy more important today than ever before. As a result, they are very closely monitored by all investors. Every public decision by Central Banks has a considerable signalling effect on the Bank’s insights regarding the expected future state of the economy. These decisions will drive fundamental variables that are of interest to us all. These variables include the level of trust within the economy, anticipations of inflation, of growth, and this will inevitably shape the evolution of international financial flows. Markets have become extremely sensitive to any announcements from central bankers and, given the role of the US in global exchanges, all eyes are on the FED and, more precisely, its governor Janet Yellen. Her speeches might seem a bit dry at first, but this is not without reason. Every word she says is shelled, deconstructed and analysed to detect insights about the United States’ economic recovery, about global economic health and stability, about the increase in interest rates that will shift investors’ attention immediately towards the American markets. The FED’s decisions are felt well beyond the borders of the United States.

 

The Federal Reserve Building in Washington, D.C., By AgnosticPreachersKid (Own work) [CC BY-SA 3.0 (http://creativecommons.org/licenses/by-sa/3.0)], via Wikimedia Commons

It is true that as growth stabilises in the US, with the job market at full-employment level and inflation picking up, the FED’s decision to raise its interest rate in December 2016 didn’t come as a surprise. The FED is expected to tighten monetary policy progressively in 2017, but the dollar appreciation means lower inflation and this will impact the pace of increase in interest rates, and we’re yet to see how the policies of Donald Trump’s administration will impact the US economy. That being said, what does the FED’s interest rate hike mean for the rest of the world?

The recent anticipations of rising interest rates are considerably changing the financial environment and will draw capital flows to the US as investors expect an increase in returns. Changes in capital flows such as this usually come at the expense of developing countries that have to deal with outflows of capital from their region. This has proven to be very problematic in the past. The decrease in demand for financial assets located in emerging markets mechanically increases the interest rates at which governments and companies within those countries finance their expenses. In a nutshell, developing countries are forced to refinance their debt at higher costs, which puts additional pressure on their budget constraints. In addition to the interest rate effect, the appreciation of USD poses great challenges to countries for which local currency is pegged to the Greenback. Because their currencies are often not liquid enough, developing countries’ debt is frequently issued in USD. The dollar appreciation raises the relative cost of repayment. We’ll have to wait and see what happens. Emerging markets are said to be more resilient than before, with improved debt structure and stronger institutions coming from recent waves of reforms, so hopefully negative effects can be minimised.

Still, the FED’s decisions are going to affect the international economic order in the coming year and we now face an unprecedented situation of homogeneity between the major central banks’ monetary policies. The European Central Bank is planning on keeping interest rates at very low levels for at least another year in anticipation of potential political instability originating from upcoming European elections, while the Bank of England needs to deal with the potential effects of BREXIT on UK’s economy and a plummeting Pound that will likely to cause inflation levels to rise more rapidly than expected. We must keep in mind that economists’ expectations are far from being always right, and there is room for potential disappointment in the US market should Trump’s administration fail to implement his campaign promises around revitalising the economy. All in all, 2017 is likely to be full of surprises. Let’s hope they’re good ones.

 


Hélène Procoudine-Gorsky is an MPA candidate at LSE, originally from Paris. Before joining LSE, Hélène completed a BSc in Business Management and Administration and a Masters in Finance at Université Paris Dauphine. Hélène has professional experience in investment banking with UBS and Société Generale.

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