This material originally appeared in the Financial Times on 27 August 2018.
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.
Second, an even stronger dollar would likely provoke more than critical tweets from President Trump. Given the president’s focus on the trade deficit, which would eventually risk widening in response to an excessively strong U.S. currency, the administration could deliver more protectionist policies. It might even resort to currency intervention to weaken the dollar using the U.S. Treasury’s Exchange Stabilization Fund, creating a conflict with the Fed’s monetary policy intentions.
An obvious option for the Fed is to pause or finish raising rates in September in an effort to stem the appreciation of the dollar. This would reduce the incentive for the U.S. administration to engage in a full-blown trade war or intervene in the foreign exchange market. The risk with this option is that an economy already turbocharged by fiscal stimulus, and close to full employment, rapidly overheats. What’s more, many market participants might conclude that Trump’s intervention via his Twitter posts has had an impact on policymakers and compromised the Fed’s credibility.
Faced with these two alternatives and the unpleasant consequences they carry, the most likely outcome is that the Fed raises rates in September but signals that it stands ready to slow down if global uncertainties and the dollar appreciation intensify. Whether such a dovish rate rise would be enough to calm the EM rout and cap the dollar’s upward trajectory is unclear.
A more effective response would be to revive the use of the Fed’s balance sheet as a more active tool. In practical terms this would mean an end to rate rises – or at the very least signaling a meaningful slowdown in the pace of future increases – but at the same time accelerating the speed at which the Fed is shrinking its balance sheet. This would change how monetary accommodation is being withdrawn rather than change the overall thrust of the policy. This could potentially slow the dollar’s appreciation or even reverse it as the gap in interest rates with the rest of the world would widen by less.
Given that Powell and colleagues spent much time arguing that interest rate increases are the primary tool for removing accommodation and balance sheet reduction should be like watching paint dry, the Fed will probably pass on this option. However, an unprecedented situation with a mountain of dollar debt in the global system and a trigger-happy president in the White House may require unconventional responses from the world’s leading central bank.
For our detailed views on the interest rate outlook and its implications for investors, please see “Rise Above Rising Rates.”
Joachim Fels is PIMCO’s global economic advisor and a regular contributor to the PIMCO Blog.