Today, the Federal Reserve raised the U.S. benchmark interest rate for the first time in a year and only the second time in a decade. That the move had been widely expected and the increase was held to a quarter of a percentage point does not detract from its significance. The U.S. dollar's central role in the global economy means that ripples from Fed policy shifts reach all countries. The central bank's most recent interest rate hike in December 2015 sparked a dramatic reaction in international capital markets as investors sold off risky assets over the next two months. Signals by the Fed that another rate hike was not imminent stopped the capital flight to safer havens. The chance of a repeat of that drama as 2017 dawns appears to be somewhat lessened by an overall improvement in the global economic outlook and less volatile markets. That said, all of last year's fragilities — such as teetering Italian banks, Chinese capital outflows, and notable dollar-denominated debt exposure in the emerging markets — are still in place, so there remains a high risk that today's move will trigger economic turbulence in the coming months.
Because the dollar reigns supreme in global markets, both as a currency in which to hold savings and as a medium used to conduct international transactions, other currencies are measured against it. (A stronger dollar weakens other currencies in comparison.) So higher interest rates in the United States increase the dollar's allure as a means to hold money because of the higher return it offers for international investors. Of course, the markets anticipate these moves in advance, so the dollar-strengthening from this rate hike had already occurred, largely over the past few months. The key question going forward is when and how often more rate hikes will occur. An accelerated cycle of rate increases will result in continued market adjustments and thus an even stronger dollar.
Donald Trump's election has increased the expectation of a higher pace of Fed rate hikes. His campaign platform was based on policies that would both increase economic activity — such as greater infrastructure spending and corporate tax cuts — and raise barriers to imports that could boost prices domestically. Such plans are recipes for higher inflation. The central bank's key job is to keep prices stable, which it does by adjusting interest rates. Higher rates raise the costs of borrowing and dampen economic activity. Thus, increasing inflation generally will lead to more rate increases. There is good reason to believe that this linkage will hold, at least for the remainder of Federal Reserve Board Chair Janet Yellen's term. In 2018, her position will be up for renewal, raising the possibility that she might be replaced by a leader more resistant to interest rate hikes, particularly if the new administration proves to be less concerned about inflation than it is about about sustaining growth. But for the time being, at least, the path to higher spending, higher inflation and higher rates resulting in a stronger dollar appears to be set.
One notable aspect of today's move by the Fed is that it increases the gap between the United States and other major currency areas like Japan and the eurozone, both of which have negative interest rates and are still following aggressive bond-buying policies. Such divergence among the world's major central banks is historically rare, and as the disparity grows, it will boost the gains to be made by borrowing in the lower-rate countries and lending in the higher-rate ones. Such flows of capital among the world's major centers can be destabilizing and indeed might have contributed to the instability on display after the last Fed rate hike. With this in mind, recent moves by the Bank of Japan (which has stepped back from its quantitative focus on bond-buying and begun stabilizing bond prices) and the European Central Bank (which has reduced its rate of bond purchases) could be seen as attempts to reduce the divergence effect ahead of the U.S. hike to keep the gap under control. That said, each central bank also had other reasons for its strategy shift, from the dwindling supply of bonds available for purchase by the Japanese bank to the overall improvement in global economic circumstances and increasing signs of general inflation as commodity prices have stabilized.
In fact, the improving global economic climate has allowed the market to largely ride out developments that at the beginning of 2016 seemed to be filling it with panic. Last December's U.S. rate hike made China's yuan look overvalued, especially following the move in 2015 by the People's Bank of China to break its currency's dollar peg. The resulting rapid increase in capital outflows prompted the Chinese central bank to spend $100 billion a month in foreign exchange reserves to staunch the bleeding. The trend has resumed over the past few months, but to a lesser degree. The yuan's decline has been consistent, and China's reserves have shrunk by around $40 billion per month, but this has not caused much disturbance in the markets. More recently, instability in the Italian banking system, corresponding to political uncertainty in the wake of Italy's failed constitutional referendum, has created a much more muted reaction than it did in January, when the banks were, at least on paper, considerably less vulnerable. In sum, global markets this year generally have been taking events in stride — even the Brexit referendum in June, when Britain became the first country to choose to leave the European Union, surely a highly unsettling event.
This market calmness can be traced to the announcement in February that the Fed would be tightening the monetary supply more slowly than had been expected. There is a danger that an accelerated rate-hike cycle, which by all appearances began today, could re-create the conditions that led to the upsets that began the year. With Italy's banks now at an extremely fragile point, and with China's $3 trillion in reserves now 25 percent lower than they were in 2014, countries around the world are hoping that another financial storm will not descend.
