3 things that really matter amid the US rate rise furore

The US Federal Reserve’s decision to raise interest rates yesterday was no surprise, given that analysts have been pouring over the proverbial tea leaves of Janet Yellen and other Fed governors’ statements for months in anticipation. The quarter-point rate hike is the first increase in nearly a decade, ending the near-zero interest rates that have prevailed since the financial crisis.

To date, most ink has been spilled in analysing the likely short-term impact of the hike. In one camp have been those concerned about the potential dampening effect on the US recovery and knock-on effects abroad. The opposing camp has vigorously advocated a return to a more “normal” interest rate environment, with higher rates. What can we make of the debate and the likely impacts of the rate increase?

First let’s take the US. Will it stifle the recovery? The Fed had been keeping a close eye on unemployment, output and inflation. The decision behind the hike was largely made based on its reading that the economy was increasingly healthy and no longer required ultra-low rates. While higher interest rates will necessarily increase capital inflows, leading to an even stronger dollar, this is not seen as a significant risk to the US economy since exports are not a major force. And while inflation remains low, the Fed seems to believe that increasing interest rates will not stifle it further. In any event, given that the rate increase is low, what matters more are expectations about the pace of future rate increases.

Divergence between the US and the EU

Perhaps more interesting than the direct impact on the US economy is what will happen in relation to other countries, and within other countries. Turning to Europe, the effect could be particularly pronounced given that while the Fed is increasing rates, the ECB is looking at providing more stimulus and thus loosening monetary policy beyond the already negative rates, given continuing economic difficulties there. European countries that are not members of the Eurozone, particularly the Nordics, have also been tinkering with negative rates. This means we will see a growing divergence in interest rates between the US and the EU, and a continuing depreciation of the euro vis-à-vis the dollar. Similar divergence can be expected with other advanced economies such as Japan.

Of greater concern is arguably the effect on developing and emerging economies. As a group these have slowed significantly after years of heady growth, with investors redirecting investments elsewhere. Higher interest rates in the US will necessarily exacerbate the capital flight from countries such as Brazil and South Africa, causing their interest rates to devalue, and in some cases exacerbating inflation.

“The whims of a few central bankers in Washington”

This would seem to suggest that the world is being unfairly subjected to the whims of a few central bankers in Washington. Yet it is important to keep in mind that what I have just described are all short-term impacts. Over the longer term how the world’s economies will progress depends on three things, which lie well within the hands of policymakers in the US and elsewhere.

 First, this is a small rate rise in one (admittedly significant reserve currency) country. What will really matter is the longer term outlook for monetary policy in the US and around the world. If US rates rise at a moderated pace this should not have a whiplash effect on the rest of the world, as investors and other actors have time to prepare and react. Equally important will be the monetary policy actions taken abroad, which if well planned and implemented, can factor in US actions but also accommodate the evolving needs of their own individual economies. Other shifts will also be at play: US monetary policy is only so important now because of the dollar’s role as a key reserve currency. As the yuan takes on a greater role in the future, this should limit the ability of one country’s policies to have such strong impacts globally.

Second, monetary policy is merely one short-term policy vehicle. In the longer term, what really matters for the US economy is a variety of policy reforms. The US remains an important engine for the world economy, and it remains a driver of global growth. Over the longer term, to ensure the health of the US economy, a number of actions are required which we have detailed on numerous occasions in our work on competitiveness and inclusive growth.  As accommodative monetary policy phases out and the US dollar strengthens, the country will have to embark on a range of reforms to ensure that productivity growth picks up. It must shore up its fiscal situation by tackling high healthcare and social security costs. Also key is improving the quality of education, and addressing educational disparities that put those from poorer socieoeconomic backgrounds at a significant disadvantage, increasing inequalities and dampening consumption and innovation potential. A return to a more collaborative government culture would ease such changes by reminding everyone that we are all in the same boat.

Third, outside the US, the timing is also critical for both advanced and emerging economies to tackle the reforms that they know they need to carry out and yet have been putting off. For example, in Europe, to foster more competitive and inclusive economies and to place the euro on a more stable footing, countries from Greece to France must tackle structural impediments which prevent markets from functioning properly, particularly for labour and services, and to place their public finances on a more stable footing. The recent refugee crisis has made this all the more urgent, with Europe’s need to absorb and benefit from the large number of new entrants to the labour market.

For developing and emerging economies, which unfortunately did not seize the opportunity to reform their economies in the heady recent years of high growth, reforms can no longer be delayed. They now understand that they cannot count on high commodity prices to drive growth forever, and must get to the hard work of improving their educational systems, upgrading infrastructure and tackling corruption and other institutional weaknesses that are holding back their ability to provide high and rising living standards to their citizens.

Overall the short term impact of the Fed interest hike is likely to be muted. But this should be an important signal for countries to put into place the factors needed for sustainable and inclusive growth.

Author: Jennifer Blanke is Chief Economist at the World Economic Forum.

Image: Traders work on the floor of the New York Stock Exchange (NYSE) shortly after the announcement that the U.S. Federal Reserve had hiked interest rates for the first time in nearly a decade in New York, December 16, 2015. REUTERS/Lucas Jackson