Everyone is watching the US Fed

Everyone is watching the US Fed

The eyes of the financial world are fixed firmly on the actions of the US Federal Reserve (the Fed), arguably the most influential central bank globally. Its decisions, whether adjusting interest rates or intervening in the bond market, reverberate not only throughout the United States but also across international markets. Currently, the spotlight is intense as anticipation builds around the possibility of the Fed initiating a cycle of monetary easing, a move that would have ramifications far beyond American shores.

Similar to other central banks, the Fed has an array of tools at its disposal, including interest rate adjustments and market interventions through bond purchases or sales, to control the money supply and, consequently, inflation. The Interest rate level targeted by the Fed affects other local US interest rates. But that’s not very different from other central banks. What sets the Fed apart is the ripple effect of its actions on interest rates worldwide. You see, the interest rate level targeted by the Fed sets the base for most, if not all other interest rates across the world, many central banks find themselves compelled to follow suit, even if their economic situation is not aligned with such moves.

The Fed has kept interest rates low pre-COVID given inflation was low. But COVID was a big shock, with so many fears of a global recession. In response to the significant economic shock caused by the COVID-19 pandemic, the Fed, like other central banks, flooded the market with liquidity to stave off a recession. With Interest rates already at a historic low, the only way out was to increase the money supply through printing money. While this strategy worked and the global economy avoided a recession, we ended up with a surge in the supply of dollars, albeit cheaper dollars. Consequently, with the tremendous increase in dollars, inflation soared, reaching close to 9%, a level not seen since the 1980s and well above the standard 2% inflation target.

After the threat of COVID subsided, the global economy was plagued by rampant inflation, which had to be brought under control. To rein in inflation, the Fed started a tightening cycle, raising interest rates to tame down inflation. Raising interest rates from nearly zero to 5% was coupled with the Fed selling a sizable part of its bonds portfolio to absorb market liquidity. This combination of raising interest rates and liquidity absorption proved effective swiftly, reducing inflation from 9% to 3% in a couple of years.

Since mid-2023, the Fed has hinted at a reversal of its tightening measures, about cutting interest rates and increasing liquidity. Market speculation is rife regarding the extent of these cuts anticipated in 2024. However, recent inflation data suggests that inflation is persistent around the 3% level and will take time to go down to the 2% target, confirming the famous economic theory of prices and wages stickiness, where prices and wages are sticky and take much longer time to adjust in reality than assumed in theory.

Adding to the complexity, the Fed operates under a unique dual mandate of controlling inflation and fostering growth, unlike most central banks which have a single mandate of controlling inflation. Thus, it needs to keep an eye on growth data plus inflation data. The latest data shows persistent inflation around 3% that needs higher for longer interest rates to tame it down, but the growth data shows close to 1% growth which is quite low and needs lower interest rates soon to promote economic growth. This diminishes the possibility of an interest rate hike and leaves the Fed with the mechanics of when and how to cut interest rates to balance between growth and inflation.

The Fed’s tightening measures have forced most world economies to follow, pushing interest rates higher, especially for emerging markets, and costing them billions of dollars more to service their debts. Given that most world economies are heavily indebted, the increased cost of debt has burdened their budgets and increased the risk of default. Lately, as the Fed started talking about the roadmap for easing, emerging markets took a breath as they saw the risk of default subsiding, yet their bond yields are still high and waiting for the actual rate cuts by the Fed.

The bottom line, the Fed’s decisions have always been critical to the global economy, impacting interest rates not only in the US, but also across the world. The Fed is unique in its effect on global markets as well as its dual mandate to balance between inflation and growth. After a tough tightening period and high interest rates, global markets, especially emerging markets, are looking forward to lower interest rates so that they can decrease their debt service burden, and this is why everyone is watching the Fed.

Omar El-Shenety,
Managing partner at Zilla Capital and adjunct faculty, AUC School of Business

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