Should we be bothered if the US Fed raised its interest rate?

Further increases in USD interest rates would accentuate outflows of USD funds, local currency depreciation and higher costs of domestic borrowing

On 16th December 2015, the US Federal Reserve Bank (Fed) decided to lift its key interest rate, the Fed Funds rate, from 0.25% to 0.5%. The rate had been kept near the zero level since 2008 in the wake of the financial crisis. Other major central banks had also largely lowered their interest rates. The hope was that cheap finance would stimulate demand and help the sagging economies of the rich countries pick up after the economic crisis.

Latest Economic Trends

This has been an uphill task, not only for the central banks but just also for the fiscal authorities. Data show that the US economy has picked up fairly well. It is chalked out to grow this year by 2.3 – 2.4% with unemployment having fallen to 5%, which most economists consider as “full employment”. The Euro area is expected to grow by 1.6% but its unemployment level is still high at 10.7%. The UK is expected to grow by 2.4% with unemployment around 5.3%.

Although India has managed to rise above the lot with an expected growth rate of 7.4%, China’s slowdown at 6.9% this year is weighing down on the rest of the developing world.

China’s falling demand for commodities and raw materials in this context has affected the progress recorded previously by commodity exporting countries, many of which are found on the African continent. Falling international commodity prices have arrested the progress they were making. Brazil and Venezuela are in negative territory with GDP expected to contract by 3-4%. South Africa has pulled itself down to around 1.4% growth this year, largely as a result of economic mismanagement.

All this to say that ‘emerging markets’, taken together, are currently facing constraints to growth. Given the rather tepid pace of economic growth in both advanced and ‘emerging market’ economies, the IMF forecasts global growth at no more than 3.1% this year. This is the international environment in which we’ll have to find a place for ourselves.

Impact of Interest Rate policies

It is in this context of overall economic uncertainty that one has to interpret the late move by the US Fed to raise its key interest rate. Central banks usually raise the interest rate when inflation is high and threatens to go higher still. The US rate of inflation is currently low at 0.2%. There is no immediate risk of inflation going out of bounds.

So, why the hike in the interest rate?

Simply to restore the credibility of the US Fed in public. For some time, the Fed has been trying to signal that the American economy is now out of the dark and not in need of interest rate stimulus for demand to pick up. In a manner of trying to instil confidence, that the economy has now turned round the corner. It had planned to increase the interest rate accordingly in October last to send this kind of signal. But, taking into account persistent global economic weakness, it refrained from acting according to expectations. Markets therefore asked whether it really meant business when speaking of hiking the interest rate. Thus, the December 16th decision was an affirmation that it had started acting.

It will be legitimate to ask why should we be bothered if the US Fed raised its interest rate and, that too, by a puny 0.25%? The answer is that it plans to raise the US dollar (USD) interest rate further into the future. Already, prior to the implementation of the interest rate hike decision, USD funds had started moving out of, among others, ‘emerging economies’, attracted by expectations of rising USD interest rates.

Several countries dependent of capital inflows from outside responded by raising their own domestic interest rates to stem the tide of outflows of the USD funds. Not only did stock markets see falling share prices, but money moving out of the country nevertheless implied that projects supported by previous such capital injections would suffer.

Moreover, it will get harder to come by additional inflows of foreign capital to support new projects if USD interest rates kept going up in future. The outflows had already caused depreciation of local currencies. Further increases in USD interest rates, as contemplated by the US Fed, would accentuate such outflows, local currency depreciation and higher costs of domestic borrowing. That’s why markets are asking: when will those increases take place and how far will the US Fed travel in this direction?

We have to be vigilant

The pattern has been for money to move out of stock markets and go into money and bond markets instead. Local politics apart, it is this phenomenon of USD outflows prompted by increase in US interest rates that makes it extremely challenging for a country like Mauritius to prevent its Stock Exchange suffering from falling stock prices or to make for a strong inflow of FDI as it used to happen in the past.

The growing international strength of the US dollar due to the USD interest hike would impact on the rupee’s value. Were depreciation to set in as a result, consumers already faced with stiff price increases of imported goods, would see further erosion of their purchasing power. There is also the risk that we may then have to struggle hard to keep down our cost of production for exports to remain internationally competitive.

At the same time, Mauritius is faced with a different situation from another quarter. What is the state of the European economy, one of our major exports markets? So far, it has been buying up our exports of goods and services (e.g. tourism) and helped maintain employment in our exporting sectors. Were the Euro area to affirm its growth prospects notwithstanding economic disturbances that may be caused on international markets by rising USD interest rates, Mauritius should be able to do business on an even keel.

We hope that will be the case. But the economic situation is markedly different between America and Europe for the present. While America has embarked on a phase of increasing interest rates, the Euro area has been doing the opposite. Already in the past, it started paying negative interest rates to banks placing deposits with the European Central Bank in a bid to stimulate demand for goods and services. In November, it depressed the negative interest rate from – 0.2% to -0.3%, meaning it is struggling to pull up the economy.

Given the mix of international economic conditions with US and UK improving but uncertainty still around for ‘emerging economies’ and the Euro area, we will have to carefully balance our economic policies to catch the upside of the evolving international economic situation. If we keep turning our narrow sights inside, we risk being able to react correctly when the train has already passed. It’s an international situation calling for our utmost attention if we don’t want to be left behind by other countries reacting proactively to the situation.

* Published in print edition on 18 December 2015

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