Unfortunately, the cure may be worse than the disease. If the Fed raises rates with a vengeance, the effects will be felt outside of its domestic purview: parts of the global economy will collapse. The global slowdown will in turn affect US growth. We then head headlong into the realm of unintended consequences.
American investors will still have no incentive to move away from American assets – and that will deprive the rest of the world of capital. Bank of America’s latest global survey of fund managers, released on Tuesday, shows the largest underweight in global equities in its history. If you’re a professional investment strategist, you won’t be fired if you stick to dollar assets or just dollar cash. Difficult to see what will change this state of mind.
It is extremely difficult for other economies and markets to compete when all roads lead to a stronger dollar. This omnipotence is destroying many currencies around the world, as the Fed’s rapid interest rate increases force faster and faster flights to quality.
Take Japan. The yen is at its lowest since 1990 with a weakening of more than 25% against the dollar last year. The country has seen its export-driven economic advantage over American rent collapse due to the need to import most of its energy and pay for it in dollars. The Bank of Japan was forced to strengthen its defense of the currency. Active intervention is now a distinct possibility, likely funding it through the sale of its reserves of US Treasuries.
For a long time, the BOJ was the only major central bank happy to pursue inflation as the path to growth for its stagnant economy. He is finally seeing drawdowns above his 2% target. At the same time, it maintained an iron fist in its bond market to keep interest rates low, often negative. However, it cannot do both of these things and keep its currency from plummeting. There are limits to how fast it can drop the yen. And this will have repercussions on the Chinese yuan, the Korean won and the Taiwanese dollar. Another bout of dollar strength – fueled by another Fed rate hike – could blow up the BOJ’s strategy and upset the rest of Asia.
China will feel entitled to react in kind to an unwanted drop in its currency. Normally it keeps it carefully under control, but it has had to let the yuan weaken by more than 10% against the dollar over the past six months. Even the world’s second currency cannot withstand the American inflationary tide.
On the other side of Eurasia, the euro and the pound have been clashing on the downside against the dollar since the spring of last year. Already paralyzed by all the spending to get out of the pandemic, Europe is now caught in the crosshairs of the energy crisis due to its dependence on Russian natural gas. Growth is evaporating before our eyes, with the UK stagnant all year and parts of the European Union sliding into recession. Deutsche Bank AG analysts expect the German economy to contract by up to 4% next year.
Like the Fed, the European Central Bank and the Bank of England are considering not only giant rate hikes as a rule, but also a reduction in banking system liquidity and the cancellation of government bond purchases. quantitative easing – all at once.
Give up hope to all who enter here.
It will happen because we have basically allowed the Fed to set interest rates for the whole world. But Fed Chairman Powell and his compatriots are hampered by myopia: all they can see is the overstretched US labor market. The resulting monetary arms race risks becoming catastrophic.
The truth is that not all economies need ever-higher borrowing costs to stifle demand; much of global inflation is supply-driven. And the world has fundamentally changed since Covid hit in 2020 and dramatically set back globalization. Yet the reaction of the Fed and other central banks remains unchanged.
The shutdown and restart of the global economy requires greater flexibility than that offered by the blunt instrument of interest rates. It is a good thing to wean financial markets and asset prices from repeated rounds of quantitative easing. But the denouement is something the Fed failed to do right – twice.
Why do central banks persist in trying to bring vast economies on top of a 2% inflation target when that is no longer feasible or desirable? Surely it’s time for a flexible range rather than a specific number. While headline inflation is expected to fall sharply next year anyway due to base effects, returning the world to much lower underlying inflation – excluding food and energy – will come at a huge economic cost.
Eventually, Fed actions will come back to bite it and the United States. By then, all the trillions of dollars of stimulus work done during the pandemic will have been unwound. What a phenomenal waste of time, money and effort.
More from this writer and others on Bloomberg Opinion:
• Jackson Hole should be a mea culpa for central bankers: Marcus Ashworth
• Inflation is terrible, horrible, not good, very bad day: John Authers
• The rate shock to come will be different but no less severe: Daniel Moss
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Previously, he was Chief Market Strategist for Haitong Securities in London.
More stories like this are available at bloomberg.com/opinion