Earlier this month Mario Draghi, the President of the European Central Bank (ECB), surprised markets when he announced no expansion to the Eurozone’s stimulus package. On Wednesday it is the Chairwoman of the Federal Reserve, Janet Yellen, who will take centre stage. The rhetoric emanating from the Fed in the build up to a potential first interest rate hike since June 2006 and the economic data suggests that a rise is all but certain. The immediate impact to the markets of a 0.25% rise, if this comes to pass, is likely to be minimal as it has been more or less ‘priced in’. However, a rate hike will not be celebrated by everyone.
Of course there are many people that will welcome the news on Wednesday as a positive sign: the Fed giving the American economy a clean bill of health after a prolonged journey back from the abyss. The US central bank has held rates at their emergency lows of 0% to 0.25% since late 2008. In doing so it has managed to steer the economy towards achieving its two key objectives; to promote job growth and direct inflation towards its 2% target. Policymakers have said for some time that the jobs side of that mandate has been fulfilled. While the garden looks rosy in the US there are external factors at play that are no doubt providing food for thought for the Fed.
Much has been written about the policy divergence between Europe and the US. Whilst the ECB decided against additional stimulus, Eurozone interest rates were cut to -0.3%. If Draghi and other policymakers continue to lower rates, which will naturally drive down the value of their currencies against a strong Dollar, the impact to US exporters could be considerable. As Marc Summerlin, managing partner of the economic consultancy, Evenflow Macro, says: “With other major central banks keeping interest rates at zero or below, the Fed will be challenged in getting all the way back to the long-run neutral rate… before the next recession starts.”
The US’ position will be further complicated if China continues to manipulate the value of the Yuan. China has already guided its currency 3% lower against the Dollar this year. With its economy struggling with falling competitiveness and job losses it would not be a surprise to see the state intervene further.
An interest rate rise could also send shock waves through emerging markets, which are dependent on the US for growth. Signs that higher US rates were approaching threw currencies of these vulnerable economies into turmoil this summer. Many developing economies will have borrowed in Dollars and have to buy Dollars with their own currencies in order to pay interest and repay loans. If the Dollar is strengthening while their own currency is depreciating it makes the Dollars even more expensive to buy. Furthermore, when the Dollar is on the up the market tends to ‘fly to safety’; meaning that local currencies are sold in favour of the Dollar, which can cripple emerging economies.
If the decision to raise interest rates on Wednesday is, as is almost unanimously agreed, a foregone conclusion. Perhaps what the world should be looking for are comments on the timing of future rate rises in an attempt to make some sense of the potential impact on a global level.