The Fed's decision to keep high interest rate constrains global economy

Editor's note: Zhijun Gao is assistant research fellow at the Chinese Academy of Social Sciences. The article reflects the author's opinions and not necessarily the views of CGTN. 

U.S. Federal Reserve Chairman Jerome Powell has announced that the Federal Open Market Committee (FOMC) decided to maintain the target rate for federal funds at 5.25 to 5.50 percent. This means the Fed has kept the 23-year high interest rate for nearly a year since it began the rate hiking to combat inflation in March 2022. Powell explained the decision not to cut the interest rate for the time being as a lack of strong evidence that inflation is moving sustainably toward the 2-percent target.

Furthermore, the FMOC suggested that there might be only one rate cut for the rest of this year, which was significantly less than its projection of three times back in March. The solid footing of the U.S. economy especially its tight job market has enabled the Fed to continuously defer the rate cut. Although FOMC seems to indicate there could be four rate cuts in 2025. Nonetheless, this is still predicated on the premise that the economic trend would be consistent with the committee's projection. If that's the case, the U.S. economy would likely end up with a "soft landing". In contrast, the world economy, especially emerging markets and developing economies (EMDEs), would see a different story.  

Further depreciation of global currencies

As the world’s reserve currency, the U.S. dollar is pegged by many countries as the anchor to determine the value of their currencies. Empirical evidence has vindicated a fairly high correlation between changes in federal funds rate and U.S. dollar exchange rate to other currencies. Bloomberg's tracking of the exchange rate shows that two-thirds of roughly 150 currencies have weakened against the U.S. dollar. Such depreciation will undermine the purchasing power of those economies as imports become more and more expensive. For countries relying on imports for intermediate goods, this would drag down their output and negatively affect people's quality of life.

Looming liquidity crisis

The Fed's hawkish stance on interest rates has resulted in massive capital inflows to the U.S. while draining liquidity in other countries. The Bank of International Settlements (BIS) global liquidity indicators (GLIs) showed that foreign currency credit denominated in U.S. dollars to non-banks overseas dropped by $87 billion in the fourth quarter of 2023, leaving the outstanding stock just below $13 billion. An empirical study conducted by the World Bank demonstrated that increases in the U.S. interest rate driven by reaction shocks (reflecting investors' belief that the Fed's interest rate policy is hawkish) would depress investor sentiment in EMDEs. This could lead to declines in investment and private consumption, and ultimately slow down economic recovery.

While the U.S. interest rate remains high, it would become more costly to pay back U.S. dollar-denominated liabilities. The BIS report in 2023 estimated that the U.S. dollar was involved in nearly 90 percent of all foreign exchange transactions. It is noticeable that U.S. dollar-denominated liabilities at global banks have been steadily ramping up since the Global Financial Crisis. For countries (e.g., Brazil, Turkey, and South Africa) that persistently run trade deficits, they tend to finance their deficits by building up dollar-denominated debt. 

In the backdrop of the widening exchange rate between these countries' currencies and the U.S. dollar, the dollar-denominated debt would become increasingly unsustainable and even unmanageable. At the same time, higher U.S. interest rate would pressure other countries to raise their bond yields in order to attract investors to purchase their bonds. This would further increase their debt burden and constrain the fiscal space.

In the midst of a resilient economy along with elevated inflation, maintaining a high interest rate might be a theoretically sensible but self-serving choice for the U.S. Nevertheless, it would be painful for the world economy to absorb the spill-over effects of a hawkish Fed policy, bringing about tremendous challenges for global economic recovery and debt sustainability for the months to come.