Fed rate hikes have consequences beyond US borders

The Federal Reserve is ready to raise interest rates for the second time this year as it fights inflation in the United States, a decision that will have ramifications well beyond the country’s boundaries.

The goal of the central bank is to restrict activity enough to keep pricing pressures under control without pushing the world’s largest economy into recession, which is becoming a growing concern after growth dropped 1.4 percent in the first quarter.

Even if policymakers succeed, many industries and countries will suffer.

– Increased loan costs – As interest rates rise, borrowers must pay more for borrowing, and banks become more selective in who they lend to.

This poses a challenge for firms and slows expansion — which can have the desired effect of cooling economic activity.

But it also will increase pressures on governments that rely on borrowing, especially emerging market nations with high debt loads.

The IMF and World Bank have warned that many countries will need relief and even restructuring to manage their debt levels, which exploded during the Covid-19 pandemic.

– Market strain –
The prospect of an aggressive central bank raising rates and slowing activity already has put pressure on financial markets.

In recent weeks, major stock indices have fallen, as a slowing economy has caused consumers to hoard their money, reducing corporate earnings and rising borrowing prices.

Treasury bond rates have risen substantially, with the 10-year note nearing 3%, indicating fears of a future recession.

Investors may become more concerned if they believe the Fed is losing the battle against inflation and will have to raise rates more quickly.

– Capital flight – When interest rates in the US or other advanced economies rise, investors prefer to withdraw funds from emerging markets in quest of higher returns.

This puts strain on economies that require capital for investment, while also weakening the local currency.

Central banks in those countries can respond with higher interest rates of their own, but that would put more pressure on the domestic economy.

In 2013, the Fed hinted that it was preparing to pull back on its stimulus policies, causing a market reaction that became known as the “taper tantrum” and weakening key emerging market currencies.

This time, the Fed has given plenty of advance warning to policymakers in those countries.

– Cooling housing, labor markets –
The Fed cut the benchmark lending rate to zero at the start of the pandemic in March 2020, which added fuel to an already strong US housing market.

Home prices have soared and builders are even further behind in their efforts to keep up with demand, a prospect made more difficult by global supply chain woes and a shortage of workers, both skilled and unskilled.

Mortgage rates began to rise even before the central bank made its first step in its tightening cycle in March, when it hiked the main rate by a quarter point, and have now risen to over 5%, reducing demand.

In March, mortgage applications dropped and home sales plummeted. While a lack of available homes has kept prices high, falling demand could alleviate the strain.

Cooling activity should also aid in rebalancing the labour market. Unemployment is at 3.6 percent, and employers are having difficulty filling open positions, which has pushed wages up and exacerbated inflationary pressures.