The Fed's increase in key interest rates by a further 0.75 percent is putting a strain on economically weaker countries and exporting nations. High interest rates are driving up the U.S. dollar – to the detriment of other countries. Because not only are imports becoming more expensive, but so is servicing loans.
Washington – The U.S. Federal Reserve continues its aggressive fight against inflation with its third unusually sharp rate hike in a row. Tight monetary policy is finally expected to noticeably lower the inflation rate in the U.S. The Fed raised its benchmark interest rate again on Wednesday by 0.75 percentage points – and Fed Chairman Jerome Powell made it clear that big rate hikes are far from over. "Without price stability, the economy doesn't work for anyone", he said.
But the central bankers' decision has implications not only for the world's largest economy, but also for economically weaker nations. And Germany is also feeling the consequences of the US interest rate policy.
International Monetary Fund (IMF) chief Kristalina Georgieva has been warning for months of a debt crisis for middle- and low-income countries. "We need to recognize that there is a tectonic shift", she said around July. The world has become more vulnerable to shocks. Currently, the impact of supply chain disruptions due to the Corona pandemic and the "horror of another war in Europe" led to runaway inflation. While central banks were right to focus on combating this with interest rate hikes, the IMF chief stressed. But with central bank interest rate hikes, global financial conditions tightened more than previously thought.
High dollar currency is disadvantage for other countries
The main problem: high interest rates drive up the U.S. dollar – to the detriment of other countries. Because not only will imports be more expensive, but so will servicing loans. The Federal Reserve's tight monetary policy is therefore being felt most by lower-income countries that borrowed heavily during the pandemic and borrowed in U.S. dollars – but do not earn dollars themselves. The higher interest rates make these loans more expensive.
This is happening at a time when inflation is already hitting many countries in Central Asia, Latin America and sub-Saharan Africa. Rising interest rates make the situation worse. In addition, when interest rates in the U.S. are high, capital can flow out of developing and emerging markets. Because when interest rates in the USA rise, investments there become more attractive. Investors currently investing in lower-income countries may decide to switch to the now more attractive U.S. market instead. There are serious implications for affected countries, which are likely to have an even harder time recovering from the catastrophic effects of the pandemic.
US interest rate policy can trigger a serious economic crisis in low-income countries – as history also shows. The consequences of the so-called Volcker shock are particularly memorable. Legendary Fed Chairman Paul Volcker dramatically raised interest rates in the 1980s in his fight against inflation. Economic growth in the USA slowed down. But that also dragged other economies down with it.
Implications for developing and emerging markets
Countries like Mexico and Chile slid into a severe debt crisis from which they did not recover for years. In Latin America, there was even talk of a lost decade. Even in later years, interest rate hikes by the Fed have repeatedly had economic consequences for developing and emerging countries.
Economists are now warning that these scenarios could repeat themselves – with devastating consequences for people in these countries. "High inflation, rising interest rates, and slowing growth have created the conditions for financial crises such as those that struck a number of developing countries in the early 1980s", Sebastian Essl and Marcello Estevao of the World Bank wrote back in June.
As an export nation, Germany is also likely to feel the effects of such a debt crisis. Because German exports could be jeopardized if the economic situation in other countries deteriorates drastically.
Fed's interest rate policy also puts massive pressure on euro. The common currency fell back below the U.S. dollar in late U.S. currency trading Wednesday and even to its lowest level since late 2002. In the summer, a euro was worth less than a dollar for the first time in around two decades. The European Central Bank has started raising interest rates much later than the Fed.
Asked if the Fed was also keeping an eye on developments in the rest of the world, including a possible global recession, Fed Chairman Powell said, "We are very aware of what is going on in other economies around the world and what that means for us – and vice versa." Of course, people try to coordinate their actions, but this is difficult given the different interest rate levels. His summary: "We all find ourselves in very different situations."