The Federal Reserve has an inordinate amount of influence over the world’s economies – and yet, in a way, it pretends they don’t really matter.
Its power rests largely on the dominance of the US dollar, which has surged in recent months as the Fed’s aggressive rate hikes made the greenback more attractive to investors. For other countries, however, this has a downside as it fuels inflation, raises the cost of borrowing and increases the risk of a global recession.
However, if you were just paying attention to the words of Fed Chair Jerome Powell, you probably would have no idea this was happening. He hasn’t said a word in his public speeches about the significant risks to the global economy if the Fed and other central banks hike interest rates to tame inflation, even during their late September meetings.
It may seem a bit odd that the Fed seems so blasé about the global economy that it’s arguably the leader. However, as a economist, I think it makes perfect sense – although there are risks.
The Fed’s domestic focus
The Federal Reserve is mandated to focus on the US economy, and it takes that task very seriously.
While central banks know all global economic data, they focus on their own economies and help them do what is best for their own nations. In the US, this means the Fed is focused on improving the US economy through stable prices and full employment.
Therefore, when the US economy slows too quickly and people lose jobs, such as at the beginning of the pandemic, the Fed cuts interest rates – regardless of the impact on other countries. If the economy is growing but consumer prices are rising too quickly, the central bank will raise interest rates.
And its global impact
Still, it is inevitable that Fed policy will affect economies, businesses and citizens in virtually every country in the world.
While all central banks influence the rest of the world, the Fed has a much greater influence due to the size of the US economy – it remains by far the largest in absolute terms – and the importance of the US dollar in international markets and trade.
About half of the world’s international debt is denominated in dollars, which means countries have to pay interest and principal on what they borrow in greenbacks. The dollar is up nearly 15% this year against a basket of foreign currencies, largely due to the Fed’s rate hikes that began in March. That means it’s 15% more expensive, on average, to fund this dollar-denominated debt — and for some countries it could be a lot more.
In addition, about 60% of all world foreign exchange reserves – the money that central banks hold to protect the value of their own currencies – are in dollars. And since most major commodities like oil and gold are valued in dollars, a stronger dollar makes everything much more expensive for businesses and consumers in every country.
Finally, when US interest rates are high relative to other countries, more foreign investment flocks to the US to get more bang for their buck. With limited money available, this draws investment away from other economies, particularly emerging markets. And it means they have to raise interest rates to keep foreign direct investment flowing into their countries, which can hurt their local economies.
Risks in a global world
Unfortunately, focusing solely on the domestic economy comes with its own set of risks.
It may sound cliche, but we live in a global, interconnected world – something that has been vividly demonstrated by the COVID-19 pandemic and the supply chain issues that have continued to spread around the world. American businesses depend on other countries for supplies, labor, and consumers.
That means even if the Fed pulls off a proverbial soft landing and reduces inflation without triggering a recession, a global slowdown could still eventually reach American shores. This could jeopardize much of the Fed’s success if the global slowdown leads to international instability or food insecurity.
While I believe the Fed is right to keep its focus on the US economy and to hit rates as far as needed on September 21, 2022, I will be watching the central bank’s economic forecasts closely. If data shows that the US economy’s inflation woes are easing, the Fed may start to think a little less about what’s happening in its own backyard and more about the impact of its policies on the rest of the world.
