World Review | Fed’s policy may derail economy and bring collapse of dollar bloc

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Fed’s policy may derail economy and bring collapse of dollar bloc

Fed’s policy may derail economy and bring collapse of dollar bloc
Washington, D.C., Feb. 11, 2016: Federal Reserve Chair Janet Yellen’s hawkish policies may cause trouble not only for the U.S., but also for other economies around the globe (source: dpa)

THE YEAR has not started well for global financial markets. Undoubtedly, one reason that stocks have slumped is that the United States Federal Reserve under Janet Yellen has started to raise interest rates and signaled that more hikes are coming, writes World Review Expert Lars Christensen.

The hawkish stance of Ms. Yellen’s Fed risks derailing the U.S. economy and throwing it back into recession. It may also exacerbate the tensions observable for some time within what we have called the “dollar bloc.”

For the past six months, Ms. Yellen has indicated that the Fed should raise interest rates. This policy stance has clearly been informed by the Phillips curve, which posits a negative trade-off between unemployment and inflation: if unemployment drops, inflation will rise.

The difficulty, however, is that even as the U.S. unemployment rate declines, there has been virtually no evidence of accelerating wage growth and inflation remains low. Judging by these surveys of price expectations, policymakers should be considering lowering borrowing costs rather than increasing them.

The general perception is that U.S. monetary policy has been very accommodative is based on looking at nominal interest rates – but these tell us little about whether the policy stance is tight or loose. Developments in the financial markets are better indicators.

We know from the textbooks that if U.S. monetary policy is tightened, then the dollar would be expected to strengthen, stocks and commodity prices should fall, and inflation expectations would decline. What are the market indicators telling us right now? Inflation expectations have been falling for more than two years and are significantly below the Fed’s 2 percent target. The dollar has strengthened dramatically since Ms. Yellen took office as Fed chair in early 2014. Finally, first commodity prices and then stock prices have entered a sharp decline.

Virtually all market indicators are flashing that monetary conditions have gradually tightened over the past two years. There is, of course, nothing wrong in adopting a more restrictive monetary policy. But the truth is that the U.S. economy is not overheating and inflation remains low. In this situation, the Fed has insisted on clamping down, and that has put the global markets under great pressure.

If American policymakers continue to focus on nominal interest rates instead of looking at a wide range of market indicators, the U.S. economy will soon be back in recession – which in the worst case could snowball into a global banking crisis.

The Federal Reserve, as a global monetary superpower, influences monetary conditions in most countries in the world. This is particularly the case for countries linked through pegged exchange rates to the U.S. dollar.

Changes in the Fed’s monetary policy stance will have a direct and indirect impact on the monetary stance of countries like China – which run a managed float against the U.S. dollar – and Hong Kong and the Persian Gulf States, which have “hard pegs” against the dollar. Any tightening of U.S. monetary conditions would bring a corresponding shift in China and Saudi Arabia as well.

As the Fed gradually started to shift its stance in 2014 and 2015, tighter monetary conditions were “exported” to other countries in the dollar bloc. This change in monetary conditions is the real reason why China is experiencing a major macroeconomic downturn, which eventually may – and likely will – force the authorities to fully de-peg from the U.S. dollar and let the renminbi float.

For a more in-depth look at this subject with scenarios looking to future outcomes, go to our sister site: Geopolitical Information Service. Sign in for 3 Free Reports or Subscribe.

Lars Christensen

Lars Christensen is a Danish economist specializing in international economy, emerging markets and monetary policy. He has over 20 years’ experience in government and banking and is the foun ...

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