NOW that the World Cup and the Tour de France are behind us, the most exciting global spectator sport is watching Ben S. Bernanke: Will he raise interest rates in August or not? And what does his decision mean for world financial markets?
When the Fed raises interest rates, global investors find dollar-denominated investments more attractive. This increased demand for American assets tends to raise the value of the dollar.
But the higher the value of the dollar, the more expensive American goods become for foreigners and the cheaper foreign goods become for Americans, worsening the balance of trade. Eventually, a highly valued dollar can lead to a drop in production in industries that are sensitive to imports or depend on exports.
International financial markets respond to interest rate changes almost instantaneously, while the real side of the economy ó production, employment, imports and exports ó adjusts over many months or even years.
If the dollar continues to strengthen this summer, we could see weaker demand for exports and increased demand for imports by next spring and summer, worsening the balance of trade.
But thatís not the whole story. The demand for dollars depends not just on interest rates in the United States, but also on interest rates on assets in other currencies, and they are moving up as well.
On July 14, the Bank of Japan raised overnight interest to 0.25 percent, ending six years of zero interest rates. Euro interest rates are also rising, mostly in response to inflationary pressures in Europe, but they are also responding to the higher rates in the United States. These higher interest rates on euro and yen assets will tend to reduce the demand for American assets, counteracting the effects of the higher interest rates in the United States.
The international financial system is like a 19th-century ballroom dance. The central bankers lead with an interest rate adjustment. Their partners, the global investors, watch them closely, trying to anticipate their every move. In the background, the waiters carry their trays of imports and exports slowly back and forth, taking their cues from the pace set by the dancers in the center of the ballroom.
But how will the dance end? It looks as if the United States interest rate increases will soon stop, if not in August then in September. The euro and yen rates will probably continue to rise for several months after that.
Given the direction of foreign rates, it is also possible that the dollar will become relatively less attractive to foreign investors over the next several months. A weaker dollar would stimulate demand for American exports, which would partly counteract the impact of the higher interest rates here. At least thatís the rosy outlook. But there are lots of things that could happen between now and then.
Disruption in the Middle East could push oil prices even higher, setting off a ripple effect on employment. Central bankers would probably pause or reverse their rate increases to cushion such a blow.
Another worry is a natural or man-made disaster: a hurricane or a major terrorist attack could rattle the markets.
China is a wild card as well. It might change its exchange rate policy, allowing the yuan to appreciate more against the dollar to cool its own economy. Or it might change its investment policy to favor euro-denominated bonds rather than investing primarily in United States Treasury bonds. Neither of these things is necessarily bad for the United States, but such changes may have a big impact on exchange rates and global markets.
There is a palpable sense of anxiety in financial markets these days, as investors contemplate these and other possibilities. Low interest rates lulled financial markets into complacency. As rates move up, volatility in stock prices has returned with a vengeance.
This is all taking place against the backdrop of continued deficit spending by households and the federal government. If we canít balance our private and public budgets, we will have to continue to borrow from the rest of the world to make up the difference. But will they continue to lend?
The current interest rate increases are an attempt to slow the economy to avoid inflation. But over the next decade, we may be forced to raise interest rates simply to attract foreign lending to finance our budget deficit.
Such high rates would damp economic growth, putting more pressure on the Fed to return to the low-interest, easy-money policy we have seen in the past few years.
Such a policy runs the risk of stimulating inflation. The easy-money policies in the past few years have had a surprisingly small impact on wages, in part because of the threat of jobs moving to countries with lower labor costs. But if the dollar fell far enough, foreign labor would no longer be a bargain, giving domestic workers more leverage in wage negotiations.
In this chain of events, an inflationary spiral would become a real possibility, making the cost of a stumble on policy higher. Let us hope central bankers can keep dancing in step as they move interest rates back to normal levels.