Wall Street watchers are calling it the most seminal moment for the global economy since the collapse of Lehman Brothers unleashed a savage financial and economic crisis in 2008.
This week, policymakers at the US Federal Reserve are finally expected to begin reversing the emergency measures they took as the world slid into recession.
Janet Yellen, the Fed’s chair, had signalled that the central bank could raise interest rates from their record low of 0.25% in September; but the downturn in the Chinese economy, and the resulting turmoil in financial markets, persuaded the Fed to stay its hand.
However, with Yellen and her colleagues due to hold their December policy meeting on Tuesday and Wednesday this week, the scene has been carefully set for the first increase in US interest rates for almost a decade. “This would be the least surprising rate hike in living memory,” says Russell Jones of Llewellyn Consulting.
If, as most analysts expect, the Fed shrugs off the latest bout of market jitters and presses ahead, the impact of what is expected to be a quarter-point hike will be felt not just in American households and businesses, which will see the costs of borrowing rise, but right across the global economy.
The US economy
Governors on the Fed’s open market committee (FOMC), which sets interest rates, have to focus primarily on the domestic economy. With firms creating jobs at a rapid pace, and GDP expanding at a relatively healthy annualised rate of 2.1% in the third quarter, it has become increasingly clear that they believe consumers and investors can withstand a modest increase.
When official figures on Friday showed that retail sales grew by 0.2% in November, Steve Murphy, US economist at consultancy Capital Economics, said: “Not that there is much doubt any more, but this supports the case for a rate hike by the Fed next week.”
Most analysts believe the immediate impact on the US economy will be modest. Phil Lachowycz of Fathom says: “In terms of how it’s going to be for the US economy, I think it will be absolutely fine. The US economy is very well prepared for a rate increase.”
However, the Fed will also be alive to the risk that, like other trigger-happy central banks since the crisis including Switzerland, Australia and Canada, it could end up reversing any rate rise because even a small increase is too much for the economy to take. “The problem I have with it is that if you look around the world over the last five or six years, most central banks that have tightened have ended up having to backtrack,” says Jones.
For that reason, the Fed is likely to use the statement that accompanies a move to signal that it is not embarking on an aggressive round of rate rises. Investors call this combination of pushing up rates while promising not to do too much a “dovish hike”. Neil Mellor of BNY Mellon says: “We’ve felt all year long that whenever the hike comes, it is how they couch their view in the statement that matters. What happens next is all-important. It’s verbal dexterity, really.”
However, not all policymakers are keen to act. FOMC member Lael Brainard used a recent speech to warn that the risks in the global economy, including the downturn in China, should give the Fed pause for thought. “Although the outlook for domestic demand is good, global forces are weighing on net exports and inflation, and the risks from abroad appear tilted to the downside,” she said. “Risk-management considerations counsel a stance of waiting to see if the risks to the outlook diminish.”
However, Yellen insists that if it does come this week, a decision to raise rates should be regarded as a sign of confidence. “When the committee begins to normalise the stance of policy, doing so will be a testament to how far our economy has come in recovering from the effects of the financial crisis and the great recession. In that sense, it is a day that I expect we all are looking forward to,” she said in recent testimony to Congress.
Even the anticipation of an increase in US rates, alongside the strengthening domestic economy, has caused the dollar to appreciate in recent months, and led investors to suck capital out of riskier emerging markets and back towards the US in anticipation of higher returns.
Many emerging economies, from Turkey to Thailand, have seen their currencies depreciate sharply and borrowing costs rise, and there will be more to come if the Fed pulls the trigger this week. Some – particularly those, such as Brazil, that are oil exporters and are suffering from plunging commodity prices – have already been driven into recession.
Economists at the International Monetary Fund, which urged the Fed to delay “lift-off”, have warned that companies in emerging economies have been borrowing heavily, largely in dollars, making them potentially vulnerable to a stronger greenback.
The IMF pointed out that business in emerging markets has quadrupled over the past decade, from $4tn in 2004 to over $18tn in 2014, and warned that if some of these loans turn sour, it will hit banks’ balance sheets, causing them to rein in lending, and potentially triggering a credit crunch.
“Shocks to the corporate sector could quickly spill over to the financial sector and generate a vicious cycle as banks curtail lending. Decreased loan supply would then lower aggregate demand and collateral values, further reducing access to finance and thereby economic activity, and in turn, increasing losses to the financial sector,” it said.
At the same time, China’s currency, the yuan, is likely to come under fresh selling pressure as the dollar continues to rise, creating a dilemma for Beijing, which has been spending foreign exchange reserves on controlling the pace of depreciation.
Mark Carney, the governor of the Bank of England, has said he expects the decision about when to raise UK interest rates from their record low of 0.5% to “come into sharper relief” around the turn of the year. Many analysts believe a Fed increase could pave the way for the Bank to act too, particularly if it is largely shrugged off by markets and consumers.
However, Adam Posen, a former member of the Bank’s monetary policy committee, says he believes there is no rush, and that the Bank should instead be fretting about the imbalances in the economy, such as the frothy housing market, and using its new “macroprudential” tools to tackle them. Its financial policy committee can intervene to slow a credit boom, by tightening how much capital banks must hold against new loans, for example.
“It’s still an unbalanced economy that’s being driven a lot by real estate, concentrated in the London area, and that’s not a very sustainable growth pattern,” Posen says. Instead of raising interest rates, he adds, “I would like to see the financial policy committee being much more aggressive about the housing market than it has.” The unbalanced state of the economic recovery was also raised in the IMF’s annual report on the UK economy, published last week.
While the US economy has been looking resilient, the eurozone is flirting with deflation; rising US rates could create a fresh challenge for the fragile euro economy if they lead to a renewed bout of global market turbulence.
Investors are intensely focused on monetary policy worldwide, reacting dramatically to any nuance, and another bout of volatile trading is the last thing European Central Bank (ECB) president Mario Draghi needs.
Draghi disappointed markets at the ECB’s latest policy meeting by failing to step up the pace of its €60bn a month bond-buying programme, which is aimed at preventing the eurozone sliding into deflation. The euro rose on the move – precisely the opposite of the effect central bankers hope to have with such quantitative easing. Many analysts expect the dollar to appreciate as the result of rising US rates, and if that continues to contribute to a weaker euro, it would be good news for eurozone exporters.
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