The implications of US monetary policy and a stronger dollar

Flickr: 401(K) 2012
Flickr: 401(K) 2012

The US Federal Reserve (the Fed) is arguably the most powerful institution in the world, with almost every single major economic event since 1945 in some way linked its policies. The Fed has many tools at its disposal. The most powerful of these tools is monetary policy, and in particular the control over interest rate policy, with US interest rates predicted to increase over the coming years according to the latest dot-plot graph[1].

Higher interest rates lead to arbitrage opportunities for investors. In simple English, this means that many investors will move funds away from European banks at 0% and ‘invest’ them in US banks or bonds at 2% with the exchange rates adjusting to reflect this (i.e. interest-rate parity theory and capital flight theory). This is incredibly problematic for the entire world economy if it is done too rapidly, as happened during the period of QE tapering (which raised US interest rates) in the early-2010s.

The major problem is due to capital flight, particularly from Emerging Markets (EM’s), which include countries such as China, Mexico, Brazil and Turkey. Indeed, the world has already seen some of these problems already as Mexico’s (USD-MXN) and China’s (look at Bitcoin which is how the Chinese move their money around) exchange rates have all plunged over the last few months reflecting Donald Trump’s election and his inflationary economic policy (higher inflation = higher interest rates).

In Mexico’s case – as it has been with other EM countries such as Nigeria – they were forced to increase interest rates five times (by 50 basis points each on each occasion) in 2016 due to the threat of the US Dollar. And that was before Trump won the Republican nomination, let alone became US President. These interest rates increases stymied Mexican economic growth; I fear that a similar thing may happen to China.

China has recently had a huge implosion of the credit via an extra 10% of fiscal stimulus and interest rates cuts which they did to prop up the stock market (SSE)…and it is quite possible that much of this economic stimulus (some of which has also gone into housing) will have to be wound down very quickly, sending ripples across the global economy. It is definitely something to watch out for.

Another major problem is that a stronger US Dollar leads to weaker commodity prices. This is because commodities are usually priced in US Dollars and a stronger greenback means that fewer US Dollars are needed. There is not a big concern regarding raw materials (Trump’s infrastructure plan), but agricultural commodities will probably be hit quite hard and this is going to be a huge problem for some of the African countries, many of whom are already facing economic and political turmoil.

The final major problem is the higher cost of borrowing. Higher US interest rates increase mortgage costs which reduces household disposable income, introducing a litany of risks to the economy. While a lot of the rules have been tightened after the financial crisis, there are still concerns regarding sub-prime automobile debt.

All of this depends on a few factors, namely the speed of interest rate increases, central bank guidance, inflation and interlinked factors. The speed of interest rate increases will depend on Trump’s economic policy which is projected to be heavily inflationary due to his huge infrastructure plan, huge tax cuts, tighter immigration controls (immigration compresses the rate of wage growth) and potential for tariffs with ‘free trade’ policy.

The central bank guidance is down to the US Federal Reserve and whether or not they can help the market calm things down. The most prominent way of doing this is with the various inflation reports that they write but more recently they have included a dot-plot graph and ‘forward guidance’ with constant hints during speeches. However, recently they have had a problem of this because oil prices fluctuate very heavily and they have no idea what Trump’s economic policies will be like in practise (although, to be fair, nobody does).

Inflation is my third caveat, and it very difficult to forecast. For example, the US economy in 2005-2008 was a perfect storm, starting off, quite literally, with Hurricane Katrina which, when combined with speculation and geopolitical problems, helped the price of oil climb steadily upwards to over $100 a barrel. Higher oil prices lead to higher food prices via the switching of wheat / biofuel production and both higher oil prices and higher food prices led to rapid increases in US inflation and rapid increases in higher US interest rates… and we all know what happened next (higher mortgage costs, sub-prime mortgage defaults, CDO’s, CDS’s, etc.).

Although, nowadays there is a bigger problem of inflation anchoring – namely that if people have deflationary expectations then consumers tend to delay purchases and businesses tend not to increase prices which makes inflation forecasting not to nigh on impossible. For example, after Brexit no-one had any idea that Aldi and Lidl would keep up the price war, or that Dave Lewis of Tesco’s would slap down his former employer over the price of Marmite. The inherent, and unavoidable, unpredictability of the world we inhabit is partly why the Bank of England got things wrong in their predictions.

Finally, some of these problems are interlinked making the situation even more complicated since EM capital flight lowers EM economic growth which lowers commodity prices and helps economic growth. For example, the currency crisis of Asia 1997 (caused by the Fed’s raising of US interest rates) led to a Russian financial crisis in 1998 and oil prices crashing to around $12 a barrel. This lowered inflation and led to lower interest rates in late 1998, only to be increased rapidly in 1999 propping the Dot Com bubble in March 2000 as oil prices recovered.

I suppose a way to to conclude would be to say that the implications of US monetary policy are bad and that stronger US Dollar is also bad. However, all of this depends on the speed of US monetary policy, central bank guidance, inflation (namely oil prices, food prices, inflation anchoring) and the interlinkages throughout the world economy.

Sam writes a regular personal blog on a range of issues, which can be found at

[1]  The US Federal Reserve dot-plot graph is a graph showing where the committee members think interest rates will be in the year ahead. It currently points upwards and looks like a space invader game.

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