Fed watch: How the hike in interest rates will affect the global economy

By Ramya Kannan

In both her speeches last week, Federal Reserve chairperson Janet Yellen has expressed her support for central bank’s decision to gradually increase interest rates. This comes at a time when the interest rates were increased in December 2016 only for the second time since the US economy began its recovery from the economic crisis. Following this, the Federal Reserve had signaled that more such increases could be expected, as they sought to employ concrete measures to avoid sudden inflationary pressure in the economy.

[su_pullquote align=”right”]The gap between President Trump’s fiscal promises and expectations on what he might actually put into practice adds to the uncertainty.[/su_pullquote]

Yellen reiterated that unemployment had come down considerably since the crisis, with unemployment rate supposedly falling below the natural rate of unemployment. With the Federal Reserve almost reaching its goal of full employment and price stability, the economy can be expected to heat up. While such a situation could usher in uncontrollable inflation, Yellen said this was unlikely since they had adopted a policy of gradual rise in interest rates. The first increase in a year from 0.5% to 0.75% was announced in December, and three more quarter-point increases are expected in 2017. These measures would allow the economy to function at a 2% rate of inflation.

However, the picture is not completely rosy. According to Yellen, the economy could expect threats from financial developments in China.

President Trump’s fiscal policies pose a large question for the global economy. | Photo Courtesy: NDTV

Moreover, the gap between President Trump’s fiscal promises and expectations on what he might actually put into practice adds to the uncertainty. Yellen’s speech, which was held a day before the President’s swearing in ceremony, indicated that this ambiguity in monetary policy will greatly affect the Federal Reserve’s future decisions.

Implication on Global and Asian markets

Any change in the US market invariably affects the global market. A gradual rise in interest rates will increase the value of US dollar, thereby redirecting the flow of capital towards the US. Moreover, it will affect the repayment of debt by countries which depend on the US, making it costlier.

Similar trends will be visible in the Asian markets. The economic slowdown in China supplemented by loopholes in capital controls which seek to regulate outflow will only be exacerbated as it becomes more lucrative to invest in the US. Moreover, devaluation of RMB against the US dollar will create more real debt and also cause a fall in demand for the Chinese currency.

Such a situation can also be expected in India, where a hike in interest rates by Federal Reserve will cause a depreciation of Indian rupee. Investors are likely to withdraw their money from Indian markets in order to invest it in the US to get better returns.

A fall in demand for imports in the US would greatly affect economies like Singapore, Hong Kong, Indonesia and Japan. The high volume of exports by these countries to the US is an important source of income, and the rising interest rate will reduce the consumption of these goods in the US economy.

Featured Image Credit: CNA Finance
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