In 1971, at the time when the United States delinked the dollar from gold, Treasury Secretary John Connally famously told a group of European finance ministers that the dollar was “our currency but your problem.”
Today, he might have said something similar about the Federal Reserve’s recent shift to a hawkish monetary policy stance. The Fed’s raising interest rates at the fastest pace in 30 years, as well as its move to an unprecedented pace of quantitative tightening, might serve the U.S. well in its fight against inflation. But it is doing so at a substantial cost to the rest of the world economy.
But the Fed has a dual monetary policy mandate from Congress. The Fed is supposed to aim at the dual objectives of U.S. price stability and maximum U.S. employment. It is not the Fed’s job to be overly concerned about how its policies might affect the rest of the world economy. That is except to the extent that economic developments abroad might affect materially the attainment of the Fed’s dual mandate.
Today, the Fed’s aggressive pursuit of its narrow mandate is complicating an already difficult economic situation in the rest of the world. Indeed, it is occurring at the very time when the European economy is likely to be thrown into a meaningful economic recession this winter by Russia shutting off its natural gas exports to Europe. It is also occurring when Chinese economic growth has ground to a halt as a result of President Xi Jinping’s zero-tolerance COVID-19 policy and when a number of emerging market economies are already defaulting on their debt.
One way in which a tighter U.S. monetary policy is spilling over to the rest of the world economy is through a considerable strengthening of the U.S. dollar. Since the Fed began raising interest rates at the start of the year, the U.S. dollar has appreciated by more than 10 percent. That has taken it to levels not experienced in the past 20 years.
The last thing that a world struggling with inflation and high international commodity prices needs is a strong dollar. The dollar’s strength, which implies weakness for the rest of the world’s currencies, has the result of adding to the rest of the world’s import costs in general and its oil costs in particular. That in turn forces non-U.S. central banks to emulate the Fed in slamming on their monetary policy brakes to contain inflation.
A tighter U.S. monetary policy has a particularly harsh impact on the emerging market economies. Higher U.S. interest rates and a strengthening dollar act as a magnet for capital to be repatriated back to the United States from abroad. That capital repatriation in turn causes the emerging market currencies to depreciate against the dollar at a faster pace.
As the World Bank keeps warning us, a tighter U.S. monetary policy now threatens to set off a wave of emerging market debt defaults by creating emerging market balance of payments problems for those highly indebted economies.
Yet another way in which an aggressive Fed might affect the world economy is through its impact on U.S. and global financial markets. Higher U.S. interest rates cause investors to cut back on risk and lead to declining equity and housing market prices. This is underlined by the more than 20 percent decline in U.S. equity and bond prices so far this year. Today, the reduction in world household wealth that this might entail could be particularly high considering that it comes on the heels of a world “everything” asset and credit market bubble.
All of this bodes ill for the world economy. With U.S. inflation proving to be more stubborn than expected, the Fed is likely to stick to its aggressive tightening path. With the Powell Fed very much focused on the U.S. domestic economy, it is likely to continue to pay scant attention to the rest of the world economy.
The Fed might come to regret largely ignoring the impact of its policies on the world economy should an economic crisis abroad have unwelcome spillover effects on our economy and financial markets.
Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.