In December 2015 the U.S. Federal Reserve (FED) raised interest rates for the first time since 2008. It has also continued to hike interest rates since then, with the last rate hike being in June 2017. The FED’s interest rate policy has far-reaching consequences, not just for the American economy, but also for the entire global economy.
Reasons for the FED’s interest rate policy
The U.S. economy has been growing at a stable rate, in part due to Donald Trump’s promises to lower taxes and increase government spending. The economic growth has led to higher demand for goods in the U.S., although this demand is hitting capacity limits and leading in the direction of inflation. While the monthly inflation rate as measured by consumer prices was still at zero percent at the beginning of 2015, it rose to over 2.5 percent at the beginning of 2017 (see fig. 1).
The response to the growing risk of inflation is a reduction in the money supply. The FED reduces the money supply by raising interest rates. The consequence of rising interest rates is that commercial banks borrow less money from the U.S. Federal Reserve. As a result, the total money supply decreases and upward pressure on inflation subsides.
The impact of U.S. interest rate policy on trade
Higher interest rates in the U.S. make it more attractive for international investors to invest their capital in the U.S. Specifically, the incentive to buy U.S. securities increases. Since these securities must be purchased in U.S. dollars, the demand for dollars increases on international foreign exchange (FX) markets. As a result, the price for the dollar rises, i.e. it appreciates.
When the dollar appreciates, U.S. products become more expensive in the rest of the world. This causes the demand for U.S. products in the rest of the world to decline. The consequences are falling U.S. exports and a rise in the American trade and current account deficit. This also brings about an increase in U.S. foreign debt.
Capital market impact of U.S. interest rate policy for the U.S.
The U.S. current account deficit means that the American economy as a whole owes money abroad. Broken down by individual economic actors, this means: The flow of capital from abroad finances the excess consumption of U.S. consumers, the high investments by U.S. companies and the American national debt.
Only this flow of capital allows the U.S. economy as a whole to consume more goods than are produced in the U.S. The additionally needed products are imported from abroad. Rising imports increase the American current account deficit, which is already by far the highest deficit in the world now (see fig. 2).
Capital market impact of U.S. interest rate policy for the rest of the world
If international investors increasingly invest their capital in the U.S., they pull this money from other countries. For heavily indebted countries, i.e. many developing nations and the crisis countries in southern Europe, it then becomes increasingly difficult to service their debts. For their part, they must offer higher interest rates in order to keep obtaining credit. This increases the risk that these countries will default on their sovereign debt.
These confluences – a rising current account deficit with the increasing debt of the given country in the rest of the world – usually lead to market reactions that bring an end to this development.
Limits of foreign debt
If the debts in an economy continue to increase, this economy’s credit rating falls. Therefore, international lenders demand a risk premium. This causes a rise in interest rates that the country must pay in order to keep obtaining credit from the rest of the world.
If interest rates rise in a country, citizens, companies and ultimately the government as well become less interested in taking out credit. This results in a decline in credit-financed demand for goods. Imports also fall for this reason. As a result, an existing current account deficit declines.
The U.S. as a special case
The outlined economic relationships apply fundamentally to all economies – with the exception of the U.S. The reason for this is the fact that the U.S. dollar is currently the sole currency that is accepted worldwide. The dollar is the world’s reserve currency. Thus, the U.S. government can issue an almost unlimited amount of dollar-denominated government bonds and rely on countries with export surpluses – currently Japan and China above all – to buy these bonds from them.
In turn, this means that the U.S. can supply an almost unlimited amount of U.S. dollars on foreign exchange (FX) markets. As a result, the U.S. can finance its debts in its own currency and is able to determine, through the FED, the interest rates paid on its debt. As long as international investors do not lose confidence in the U.S. dollar as the world’s reserve currency, the U.S. can issue debt and be indebted to the rest of the world in its own currency, almost without limitation. Nothing will change for the foreseeable future in this regard. Even if investors’ confidence in the U.S. dollar has decreased since the beginning of the year and the dollar has lost value, there is currently no currency in sight that could assume the role of the dollar.
Economic policy consequences
The current increase in interest rates in the U.S. is moderate and appears to be fairly harmless. In reality, however, there may be grave consequences for international trade and the financial system as a result of the global relationships outlined here:
- Highly indebted economies must fear that international investors will pull their money out of the country. These countries are at risk of default without this capital. If such a default affected larger economies, possibly even in Europe, this would put the global financial system under significant pressure.
- In regard to the U.S., it should be noted that a central mechanism for limiting the U.S. current account deficit and thus the related foreign debt is lost. This threatens to make the global current account imbalances even greater since the rising current account deficit in the U.S. faces growing current account surpluses in other countries.
On balance, the change in U.S. interest rate policy could become a major threat to the global economy.