The US Central Bank, unless surprised, will raise its interest rates on Wednesday, the second hike in less than two months, with the aim of curbing runaway inflation.
There are many questions about the future monetary policy of the Federal Reserve (Fed), which, except as a surprise, should raise its interest rates on Wednesday, and the effects that could be felt on the global economy.
In the United States, the challenge is to dampen price pressures without sending the world’s largest economy into recession. A delicate exercise now that the US economy has already slowed considerably. GDP even shrank by 1.4% in the first quarter and inflation is at its highest point in 40 years.
Wednesday’s increase should be half a percentage point, the first since May 2000, bringing interest rates between 0.75% and 1%. In March, the Fed signaled the possibility of six more hikes by the end of the year. A majority of economists are now forecasting an even more aggressive increase of three-quarters of a percentage point at the June meeting, which would be a first since 1994.
What impact on the markets?
Higher interest rates can have a negative effect on the stock market. With higher borrowing costs, companies could invest less. If their costs are higher and their business is less thriving, a drop in revenues and profits can affect the value of their stocks.
We also cannot rule out a psychological aspect of how investors perceive market conditions. Traders could resort to more defensive investments without waiting for the long process of rate hikes to be felt across the economy.
What impact on emerging market debt?
Emerging and developing economies that take out dollar-denominated loans run the risk of being overwhelmed by the cost of credit. The International Monetary Fund (IMF) and the World Bank have been warning for months about the risks for these countries of a too rapid interest rate hike by the Fed.
They were already heavily indebted before the pandemic, but have built up even more debt during the health crisis, to the point that 60% of low-income countries are already over-indebted or approaching it.
What effect on capital flows?
When interest rates rise in the United States or other advanced economies, investors withdraw money from emerging markets they’d flocked to in search of more profitable returns. In 2013, even before the rate hike, investors had anticipated a decline in the Fed’s liquidity injections, which sent Brazilian, Turkish and Indian currencies down.
Is there a risk of a recession?
Investors are especially looking forward to Fed Chair Jerome Powell’s press conference on Wednesday for comment on how interest rates could rise after that meeting.
The Fed will also likely begin to trim its $9 trillion asset portfolio from June, at a much faster pace than it had previously reduced its holdings five years ago. The challenge is to moderate inflation without sending the world’s largest economy into recession.
Concerns about this have increased in recent weeks as growth slows. The experts would like to reassure you that consumption, the historical engine of growth in the United States, is holding up. But in a context of war in Ukraine, a slowdown in the Chinese and European economies, a recession no longer seems a distant risk.
Fed leaders currently estimate they will be able to bring inflation back to their 2% target without raising interest rates above 3%, in order to avoid sluggish demand. This, they say, is a “neutral” range designed not to stimulate or slow economic growth.