December 17, 2015
After months of expectation, on Wednesday the Federal Reserve finally ended the suspense and raised interest rates by a quarter of a percent. Considering the buildup, it would be easy to see the event as something of an anticlimax. The interest rate is ultimately expected to get up to mid-single digits, so a 0.25 percent raise from near zero is pretty underwhelming in the grand scheme of things. And given the length of the run-up and the warnings they have received, the markets ought to be prepared for the news, and the immediate effects will be almost fully priced in. The dollar is not likely to suddenly take off. (It has been appreciating strongly for 18 months already.) Many around the world will be going to bed tonight wondering what all the fuss was about.
But even if the changes and effects of the move are not immediate, that does not mean that they are not immense. This day is likely to be remembered well into the future, for better or for worse, because it bookends a remarkable period in U.S. monetary history: an unprecedented seven years in which interest rates were kept at the “zero-lower bound,” the lowest number possible without going into negative figures. To put this into perspective, the Bank of England, the grandfather of monetary policy, which can trace its interest rates back to 1694, had never hit zero before 2009, let alone spent seven years there.
The unprecedented nature of the past seven years raises questions about what might happen as we emerge from it and adds an air of uncertainty about the correct timing of the decision to raise rates. Raising rates could derail the recovery, but there is also an argument that a return to normality is needed at some point, whatever the risks, and the U.S. economy appears to be strong enough now to attempt it. In any case, the Fed looks like it will proceed cautiously.
The U.S. economy might be robust enough for this move, but that is not the case elsewhere. Seven years of ultra-low interest rates created an abundance of capital in the world’s reserve currency — the dollar — and these dollars spread around the globe in search of returns. This created a climate of easy money for countries that are not necessarily used to it, and some — such as South Africa, Turkey, and places in Latin America such as Colombia and Mexico — came to rely on this foreign capital. They now face an immediate future of economic hardship, with a financial crisis or a period of sharp fiscal tightening likely to ensue.
There is unusual international power resting in the hands of Fed Board Chair Janet Yellen and the Federal Reserve’s Governing Board. That so many dollars are spread around the world, and that so many countries hold them in their international currency reserves, gives the United States the ability to cause great waves merely by adhering to its own domestic monetary policy goals. Therein lies the inherent unfairness in the international monetary system: Larger players, particularly the holders of the global reserve currencies (including the euro), can make policy according to their own needs, and the rest of the world must adapt.
But the day also brought evidence that these dynamics are changing. The U.S. Congress is preparing to finally ratify the 2010 review of the International Monetary Fund’s voting rights, which would double the financial resources of the IMF as every member doubles its quota, and it will give emerging markets — such as China, India and Russia — more clout in the institution, reflecting their growth in the past decade. This demonstrates the shift that is underway, in which the European voice grows muted and newer voices are heard more on the global stage. Nevertheless, the cogs of international reserve currency allocations tend to turn more slowly than those of voting rights in institutions, and it is likely that the dollar will retain its dominant position for a long time to come.
We now enter a new phase in global economics, and it is unfamiliar territory. The Fed’s tightening move is notable not just because it follows an extended period of zero rates, but because it also marks the beginning of a period in which the world’s central banks are moving determinedly in different directions. While the Bank of England is closer to tightening than loosening, the European Central Bank and the Bank of Japan are both committed to quantitative easing programs (indeed, the European Central Bank extended its program this month), and the People’s Bank of China currently looks happy to let the yuan slip downward against the dollar. After an extended period in which the world’s central banks have largely followed each other — and indeed their chosen path has tended to be dovish — we now have a split.
The currency traders may be delighted, since this gives them opportunities to make gains from the relative movements, but for much of the rest of the world’s financial markets it creates many more questions than answers. A young generation of traders around the world has grown up in circumstances that have ended, and it will take a while for them to learn the new rules. While they are doing so, big swings in the capital markets may become the new norm. Thus, while the developing world faces challenges as the dollars flow out, the developed world, which is home to the capital markets, may also encounter its fair share of uncertainty as a result of today’s announcement.