How the US Federal Reserve’s big decision will reverberate across global economies

The Federal Open Markets Committee, the interest-rate setting body of the Federal Reserve, will meet today and tomorrow to discuss when to end the longest period of near-zero interest rates since the dawn of central banking.

Because of the large number of countries – including the UAE – that have pegged their currencies to the dollar, the Fed effectively sets interest rates for a large number of the world’s central banks.

But the Fed is not mandated to take into account the effect of its monetary policies on these countries. It is mandated to pursue two objectives – an average consumer inflation rate of 2 per cent, and full employment – estimated as an unemployment rate of between 5.0 and 5.2 per cent.

A number of prominent US economists think the Fed should hold off on interest rate rises. Former treasury secretary Larry Summers says the Fed should follow a strategy of “not raising rates until it sees the whites of inflation’s eyes”.

One debate centres around what exactly constitutes full employment. How Americans work has been changing. Total employment and job vacancies are both strongly up compared to the recession that followed 2008, but productivity growth and wage growth both look anaemic, while freelancing and part-time work have increased.

The Fed’s full employment target of 5.0 and 5.2 per cent is based on experience of the economy under Bill Clinton – but labour market changes mean that this is not necessarily the lowest unemployment can reach before inflation kicks in. “Whatever the unemployment rate at which inflationary pressures become significant – a key question for policymakers – we know that it is far lower than the rate today,” writes the economics Nobel laureate Joseph Stiglitz in an article for Project Syndicate.

Professor Stiglitz points to the 10.3 per cent US under-employment rate – which takes into account precariously employed workers and those seeking part-time work. Wages are flat or declining, youth unemployment among African-Americans is above 50 per cent, and inflation is unlikely to exceed 2 per cent any time soon. “The call right now is not a close one. On the contrary, it is as close to a no-brainer as such decisions can be: now is not the time to tighten credit and slow down the economy.”

Another dovish sign comes from abroad. China, which has buoyed global markets as it continued to grow strongly, and soak up commodities, raw materials and intermediate goods, now looks to be slowing as it transitions from a government-planned, investment-led economy to a consumption-led economy. This could harm global growth, which in turn reduces the likelihood that the American economy will remain at full employment.

But assuming that the Fed does opt for higher rates – what will the impact be?

The initial hike is likely to add 0.5 percentage points to the Fed’s current funds rate. That will eventually push up interest rates in the Gulf, as well as further strengthen the region’s already strong currencies.

The UAE Central Bank is likely to raise its main interest rate to prevent pressure on the dirham-dollar peg. That will push up the Emirates Interbank Offered Rate, which represents the cost of short-term funds for banks.

But Monica Malik, chief economist at Abu Dhabi Commercial Bank, said that it’s possible that Gulf central banks could choose not to immediately increase rates.

“The majority of GCC countries reduced their benchmark lending rates by a lesser degree than the US in 2008 and 2009, thus widening the differential [between local and US interest rates],” Ms Malik wrote in a research note.

The UAE Central Bank’s interest rate stands at 1 per cent – above the Fed’s target interest rate range of 0-0.25 per cent.

“Some GCC [central banks] could initially respond to an increase in US interest rates by raising their benchmark deposit rates, while keeping their lending rates unchanged. Maintaining an accommodative monetary environment will likely be a key objective given the signs of weakening non-oil activity, contained inflation, and tightening liquidity in the banking sector,” she said.

But the mix of low oil prices and concerns about capital outflows from emerging markets, mean that Gulf central banks are more likely than not to follow the Fed in raising rates, according to Jason Tuvey, an emerging markets economist at Capital Economics.

This will lead to higher borrowing costs and slower credit growth, which will affect consumer demand, government and government-related entities (GREs) debt, and the real estate market, said Mr Tuvey.

“Credit growth has been a big support for demand across the region over the last few years, but could now slow.”

GREs have used the era of near-zero rates to restructure much of their debt at lower interest rates, Mr Tuvey said.

“It’ll only be if they roll over debt that they will face higher borrowing costs,” he added.

“Government borrowing costs will also rise, which will be a concern for other countries in the Gulf like Saudi Arabia, which have been forced to borrow more over the next few years because of their budget[deficits],” he said.

But sovereign wealth funds have large holdings of US Treasurys, whose prices will rise in line with the interest rate – so sovereign wealth funds might actually benefit somewhat from higher rates.

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