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How could Federal Reserve rate hikes affect the world economy?

business-articlesHow could Federal Reserve rate hikes affect the world economy?

The Federal Reserve is the world’s largest central bank, presiding over monetary policy for the world's largest economy.

As such, its decisions ripple out through global markets.

At its January policy meeting, the Fed signalled its intention to start raising interest rates from March – at a potentially aggressive pace – to curb inflation, which is at a near four-decade high.

So, how could a Fed rate hike affect the world economy? We look at the potential risks and benefits of rising US interest rates.
 

Borrowing costs could increase

When interest rates go up, so do borrowing costs. This is felt most in the country where the rate hike takes place. For instance, when the Bank of England (BoE) hikes rates, UK borrowing costs increase. But the actions of the US central bank have much more far-reaching consequences.

The US dollar is the de facto global currency. USD makes up about 60% of known central bank foreign exchange reserves. In addition, many global commodities are priced in dollars, almost 40% of the world’s debt is issued in dollars, and around 90% of forex trading involves the US dollar.

As a result, when borrowing costs go up in the US, they go up around the world.

When borrowing is more expensive, people tend to put off financing projects: we may see a drop in companies and entrepreneurs securing business loans and a dip in households applying for mortgages. Consumer credit, and therefore spending, could go down. Stock values could fall and growth rates may slow.

By increasing rates, the Fed hopes to cool off America’s overheating economy, but other economies that aren’t running as hot could start to feel the chill.
 

Risks to Asian and emerging market (EM) economies

This could be particularly true in Asian and EM economies.

Ahead of the Fed’s decision, Changyong Rhee, Director of the Asia and Pacific Department at the International Monetary Fund (IMF), warned that Fed rate hikes ‘can definitely slow down Asia’s recovery and growth’, at a time when China’s growth is already waning.

Why? Well, since the 2008 financial crash, Asia’s share of the global debt has jumped from 27% to 40%.  As mentioned above, rising interest rates in the US have the potential to push up borrowing costs globally, so higher debt means higher debt repayments.

As for EM economies, they often hold a huge amount of dollar-denominated debt, accounting for a third this debt worldwide. Rising US interest rates and a stronger US dollar (USD often strengthens when US rates rise) can make these debts unmanageable. The ‘fragile four’ – Indonesia, Brazil, Mexico and South Africa – could be particularly vulnerable.

In addition, investors may move their US dollars out of riskier EM assets and into safe havens, such as US Treasury bills. These capital outflows and higher debt repayments could weigh on the affected economies while leaving governments and central banks with less room to stimulate growth.
 

Other currencies lose global value

Of course, the stronger the US dollar, the weaker other currencies are in relation to it. And as the US dollar is the most widely used currency globally, non-dollar currencies can effectively depreciate when it comes to global trade and transactions.

This is where having a forex risk management strategy comes in handy. Specialist currency providers often offer the most competitive exchange rates, while tools like forward contracts and options can help protect you from negative shifts in the currency market.
 

Commodities market could suffer

As mentioned, many global commodities are priced in US dollars. So when the dollar strengthens, and other currencies depreciate, commodities often become more expensive in these non-dollar currencies. And when commodities become more expensive, demand tends to decline.

As a result, economies that rely on commodity exports – like Canada, Australia and New Zealand – could see their export revenues shrink, while non-dollar importers could face higher costs.
 

Boost foreign trade

One benefit of higher US interest rates and a subsequently stronger dollar is that they could increase foreign trade.

As USD gains more purchasing power, US demand for imports increases. Therefore, exports to the US could get a boost.

The top US imports are cars, crude petroleum, computers, broadcasting equipment and packaged medicaments. So, exporters of these products – and businesses within the value chain – could see an uptick in demand.

The US is the UK’s largest export market, and three of the UK’s top exports – cars, crude petroleum and packaged medicaments – align with America’s top imports. As such, UK exporters might benefit from rising US interest rates.
 

Possible long-term effects?

The Fed’s decision to raise rates is, in part, a vote of confidence in the US economic recovery. The hope is that the US economy will be able withstand less favourable financial conditions, while higher rates will also bring down inflation.

That’s the ideal scenario. However, uncertainty still remains. The global economic recovery looks bumpy, to say the least, and there’s no way of knowing whether we’re leaving the pandemic behind or just emerging from the most recent wave.

Even if Covid were to vanish overnight, the economic aftermath is hard to predict (just look at central banks’ changing inflation forecasts in 2021). As a result, the true impact of a Fed hiking cycle may not be apparent until the process is well underway.

Currencies Direct

Currencies Direct

Currencies Direct is one of Europe's leading non-bank providers of currency exchange and international payment services. Since we were formed in 1996, we've maintained our focus on providing innovative foreign exchange and international currency transfer services to corporations of all sizes, online sellers and private individuals. We have also expanded our services to provide dynamic and pioneering "business to business" solutions to help companies, tier 2/3 banks and other non-bank financial institutions to process their international payments. Our headquarters are in the City of London (United Kingdom) and we have operations in continental Europe, Africa, Asia, and the United States. Currencies Direct is jointly owned by private equity firms Palamon Capital Partners and Corsair Capital.

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