Fed gears up for interest rate turn | Business| Economy and finance news from a German perspective | DW | 15.12.2015
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Fed gears up for interest rate turn

The US Federal Reserve is set to increase the core interest rate it charges banks for overnight loans for the first time in nearly a decade. How will markets and economies react to the turnaround?

Ralph Solveen, deputy head of Commerzbank's research group, is confident: "On Wednesday, it'll finally happen. The US central bank will raise its core interest rate for the first time in nine years, and with that, it'll end its long era of effectively zero interest rates."

"Three, two, one - liftoff!" is a catchphrase some economists have used in describing the long-awaited, oft-delayed move.

It's going to have consequences - not only for the US economy, but also for Europe, Asia and emerging economies. Unlike the Fed, the European Central Bank (ECB) looks set to carry on with its near-zero interest rate policy for a long time to come. For one thing, ECB president Mario Draghi is still zealously fighting a supposed threat of deflation in the eurozone, and for another, the post-GFC (global financial crisis of 2007-2008) recovery remains much too fragile to risk any increase in interest rates at this time.

Euro-dollar parity?

If the Fed increases its interest rate, other interest rates will also rise. That will cause more investment money to be invested in dollar-denominated fixed-rate assets such as bonds. The increase in demand for dollars will increase their relative price on foreign exchange markets - i.e. the dollar will rise in purchasing power compared to the euro or other currencies.

Fed chairperson Janet Yellen

Janet Yellen, Fed chairperson, had to finally increase interest rates in line with widespread expectations, in order to maintain credibility

Right now, the exchange rate is at 1.09 dollars to the euro. As the Fed increases the core interest rate in dollar-denominated financial markets, the exchange rate will drop - quite possibly all the way down to 1:1 parity between the dollar and the euro.

European companies that sell export goods priced in dollars should benefit, since they will be able to trade those dollars for more euros - even as the wages they pay in euros remain the same as before. European exporters sell their goods in exchange for dollars not only in the US, but also in many other markets, including Asia, where international trade mostly remains dollar-denominated.

In general, prices for globally traded commodities such as oil, copper or iron ore are usually priced in dollars. If the dollar strengthens, it takes fewer dollars to buy a ton of any commodity. That means their prices sink in dollar terms - but increase in euro terms.

If raw materials prices increase in euro terms, that might help generate some core inflation in the eurozone. That should cheer up ECB president Draghi: With every bill Europeans pay in dollars, we'll be importing some inflation, and he's been trying so very hard to generate some inflation in the eurozone.

How strong of a braking effect?

How far the euro drops in relation to the dollar will depend on how sharp a trajectory of interest rate increases the Fed embarks on for the dollar economy.

Goldman Sachs logo

A dramatically stronger dollar compared to two years ago, relative to the euro, makes it much cheaper for US investment megafirms like Goldman Sachs to buy up European assets

"Many analysts expect a very slow, gradual trajectory from the Fed, because its governors are worried that the American economy will have difficulty adjusting to higher rates and an even stronger dollar," according to Commerzbank's Ralph Solveen.

"According to our analysis, however, slightly higher interest rates will have barely any effect on private consumer spending. And the stronger dollar should dampen the US economy in the coming quarter only a little bit more than it's already doing."

That's why Commerzbank's analysts expect "that the Federal Reserve will increase interest rates a bit faster than markets expect."

Although the consequences of the modest interest rate rise of a quarter of a percent or so are likely to be easily bearable for Europe and the US, the situation looks altogether more dire from the point of view of emerging economies.

Their governments will have to face stronger capital outflows. Over the past several years, emerging markets have profited from the Fed's ultra-low interest rates, since investors in the dollarized world went looking for investment opportunities offering higher rates of return in other currencies, and in regions with faster-growing economies.

Now, however, investors are pulling their money out of emerging economies, many of which have experienced growth slowdowns due to commodity price collapses caused by China's slowdown. US financial paper is now likely to offer improved comparative returns and lower risks, since US growth seems stable.

Adair Turner, Chief Economist, Institute for New Economic Thinking

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Pause in rate rises next summer

Commodity exporters like Brazil or Russia, already stuck in harsh recessions due to collapses in the price of oil, copper, and other raw materials, are being hit by a double whammy. A stronger dollar tends to make investments in commodities less attractive for foreign investors, since their dollar-denominated price is likely to fall further. A Fed rate rise is likely to put even more pressure on hard-currency revenues of countries with economies dependent on commodity exports.

"Until now, the Fed has gone to a lot of trouble to avoid giving the impression that its monetary policy is very mechanistic," Commerzbank economists wrote in an analysis. "The leading interest rates aren't intended to be raised according to a wholly predictable path. The US central bank is reserving its right to react to changes in economic data or strong market reactions with pauses in its schedule of interest rate increases."

Many economic policy-makers in emerging markets are presumably hoping a pause in Fed rate rises will occur sooner rather than later.