Damned if they keep raising, damned if they don’t. Federal Reserve Chair Jerome Powell and his colleagues face a difficult choice over the next few months – and it is one that could have unpleasant ramifications whatever they decide.
The first option for the Federal Open Market Committee (FOMC) is that it continues to deliver on the current plan: Raise rates again next month and stick to the guidance of four additional rate increases by the end of 2019. This can be easily justified by the U.S. economy’s progress toward the central bank’s dual objectives of full employment and 2% inflation as Powell emphasized again in Jackson Hole.
However, the Fed is not only the U.S. central bank but also the pacemaker for the global credit cycle. Courtesy of ultra-low U.S. interest rates, quantitative easing and a relatively weak dollar following the global financial crisis, borrowers within the U.S. and, even more so, beyond have piled into U.S.-dollar-denominated debt. According to BIS data, dollar credit to non-bank borrowers outside the U.S. doubled to $11.5 trillion since the financial crisis. Within this, dollar debt in emerging markets (EM) surged from about $1.5 trillion 10 years ago to $3.7 trillion this March.
As the Fed absorbs excess liquidity by shrinking its balance sheet – and the U.S. currency and interest rates rise – this dollar debt binge has come back to haunt borrowers. The weakest links with questionable domestic fundamentals and policies, such as Turkey, are being hit particularly hard.
With the global credit cycle turning, the Fed’s adherence to the traditional modus operandi of monetary policy could backfire in two ways.
First, sticking to the plan of further rate rises laid out in the FOMC’s dot plot risks instigating a “dollar doom loop.” The currency could continue to appreciate, putting further downward pressure not just on emerging market assets and economies, but on banks and exporters in countries with significant exposure to EM, such as Europe.
What’s more, a further divergence between the economic performance of the U.S. and the rest of the world would tend to push the dollar even higher. At some stage, this would likely feed back negatively into the U.S. corporate sector via lower energy prices that tend to fall when the dollar appreciates.