Last year, a few influential voices urged the Federal Reserve not to raise interest rates out of concern that it would slow global growth and fuel financial disruptions. Fed officials listened politely, then hiked rates in December and subsequently paused. Given recent developments in the foreign-exchange markets, some of these voices may now be wondering if the Fed should resume its rate increases.
This seemingly inconsistent thought process reflects the unfavorable conditions that have emerged from the prolonged pursuit of a highly imbalanced economic policy mix by the world’s most-systemically important economies. This trifecta of conditions includes a configuration of advanced economy exchange rates that appears to no longer respond “normally” to interest-rate differentials; partial policy measures whose impact pales in comparison to the effects that would result from a more comprehensive approach, and growing risks of transmitting waves of instability through global financial markets.
In normally functioning economies, a rise in interest rates would help slow the economy by making borrowing-driven consumption and investment more expensive. It would have a concurrent impact on the cross-border flows of funds, attracting higher inflows as investors seek to capture the greater financial returns. The resulting appreciation in the currency, assuming it is floating relatively cleanly, also would make exports less competitive, adding to the economic slowdown.
Before the Fed’s policy meeting in December, some — including the International Monetary Fund — understandably worried that an interest rate hike by the world’s most important central bank might disrupt the global economy, which had yet to establish a sufficiently firm economic and financial footing. Even though these experts acknowledged that the U.S. was the best positioned of the advanced economies in terms of growth and job creation, they expressed concerns that higher Fed rates could suck capital out of emerging countries, lead to a more general slowing of growth and risk global financial instability. Developments in January and early February seemed to confirm their concerns, even though a Chinese growth scare probably had a much bigger influence on markets than the Fed’s policy move.
At least on paper, the Fed’s small step towards tightening monetary policy was more than offset by the policy loosening that followed by three other systemically important central banks — China, the euro zone and Japan. Deploying a combination of lower interest rates, including negative ones in Europe and Japan, and stepped-up asset purchases, the three banks made a valiant effort to stimulate demand, both directly and by attempting to depreciate their currency.
A few months later, the impact on global currencies has been counter-intuitive, and counter-productive for global rebalancing. Instead of depreciating, the euro and the yen have appreciated notably against the dollar, adding to the headwinds for growth and inflation. Last week, the U.S. Treasury placed five countries, including China, Japan and Germany, on a watch list. Their foreign-exchange practices will be closely monitored to determine whether they are obtaining an unfair trade advantage.
So what explains these topsy-turvy foreign-exchange markets?
As I argued in March, beyond a certain point, interest-rate differentials can lose their effectiveness in driving exchange rates. And even if this were not the case, the hoped-for impact on growth would be defeated by the more pervasive problems of insufficient structural growth engines, aggregate demand deficiencies, alarming inequality and pockets of excessive indebtedness.
This is another reason to warn against the continued reliance on what has proven to be a highly imbalanced economic policy stance. The longer the systemically important countries persist with an excessive dependence on central banks — and fail to pivot to a more comprehensive policy response — the greater the risk that the global economy will incur the costs of currency volatility while capturing few, if any, of the benefits of hoped-for exchange-rate moves. All the while, currency movements could become even more counter-intuitive.