Global Implications of the Fed's Rate Hikes
On November 2, the Federal Reserve voted once again to raise interest rates by 0.75%. This decision is the latest in a long series of rate hikes designed to combat record-setting US inflation levels, which reached 7.7% year-over-year in October. Given that the Fed’s target inflation rate is 2%, market observers expect the US’ central bank to continue on its hawkish path until interest rates reach 5% in March 2023. Multiple economists have warned that in doing so, the Fed risks drastically over-tightening the economy, precipitating a recession.
An American recession is not the only risk of the Fed’s hawkish monetary policy. Rate hikes may also reverberate internationally. As historical interest rate increases make clear, the Fed’s actions may limit credit availability to the Global South, threatening the international transition away from fossil fuels. The current shortages of energy in global markets exacerbate this risk. Instead, the Fed must explicitly consider developing markets when making monetary policy decisions. The American economy is not isolated, and if the Fed does not account for the risk of a global contraction, its actions may end up doing more harm than good.
The History of Rate Hikes
2022 is not the first time the Fed has used aggressive rate hikes to curb inflation. Higher interest rates make it more expensive to borrow and spend, which can be effective at reducing prices but also tends to drive down real economic activity. The first–and most drastic–use of interest rates to control inflation occurred between 1979 and 1982, when Federal Reserve Chair Paul Volcker raised rates to nearly 20% to combat the “stagflation” of the late 1970s. The “Volcker shock” reduced inflation, but at the cost of a sharp recession, in which unemployment reached nearly 11%. In 1990, following the outbreak of the Gulf War, the Fed once again raised rates, triggering another decline in economic growth. Similar rate hike-induced recessions occurred in 2001 and arguably in 2007 as well.
But the effects of these policy moves are not limited to the domestic economy. Academic research suggests that such rate hikes also have global effects. A 1998 paper by Barry Eichengreen and Frank Rose argues that low US interest rates may stimulate investment in emerging market economies (EMEs) by incentivizing investors to seek higher yields abroad and raising EMEs’ creditworthiness by making it easier to pay back debts. As rates increase, however, foreign investors are likely to curtail their investment in favor of safer, high-yield opportunities at home. Consequently, Eichengreen and Rose find that interest rate increases in northern, industrialized economies are strongly correlated with the onset of banking crises in southern economies.
Take, for instance, the 1982 economic crisis in Latin America. During the 1970s, the Latin American countries received vast amounts of investment from international creditors, fueling an economic boom in the region. However, following Volcker’s “shock therapy,” rising interest rates in the Global North expanded Mexico’s debt burden beyond its repayment capacity. The result was a sudden curtailment of international credit across the region, prompting mass defaults and reschedulings and forcing Latin American countries to redirect foreign capital from poverty relief or social programs to service their debt.
Global Implications
This history of credit contractions poses special danger to global decarbonization efforts. The Fed’s interest rate hikes risk exacerbating global climate inequities, wherein wealthy nations can muster the financial resources to escape the worst effects of a changing climate while leaving the Global South to endure extreme economic deprivation and environmental degradation. The flooding in Pakistan this summer is one of the latest manifestations of these conditions: Pakistan contributes less than one percent of global emissions, yet the abnormally intense monsoon season–enabled by emissions–killed nearly 2,000 people and created an acute survival crisis affecting over 10 million children.
The world’s energy markets exhibit similar inequities. As Russia’s invasion of Ukraine pushes up global energy prices, the UN Conference on Trade and Development has warned of a “potential “scramble for fuel”, in which only those countries paying the highest price can gain access.” Such a scenario would exacerbate global “energy poverty” in which consumers in the global south cannot afford energy to, for example, cook or light their homes. The figure below illustrates this trend. Rising energy prices have pushed EMEs’ current account deficit $2.5 billion over its baseline, indicating that energy will become increasingly unaffordable for low-income countries.
Transitioning to renewable energy could reduce such energy inequities: a recent study by the Rockefeller Foundation found that new, decarbonized energy infrastructure would dramatically improve energy access in Africa and Asia by 2030. Yet such a transition requires significant mobilization of foreign capital. The Rockefeller Foundation’s report, for instance, recommends $130 billion of additional funding for renewable energy in Africa and Asia. Similarly, in its 2021 flagship report, the International Energy Agency argues that a transition to clean power in developing markets will require large-scale private international investment. Yet if the Fed continues down its hawkish path, it will force foreign investors to curtail their provision of capital just when it must be expanded, leaving the Global South to suffer a perpetual energy shortage even as the US and Western Europe secure access to more sustainable and reliable forms of energy.
As some observers have pointed out, the war in Ukraine generates opportunity as well as deprivation. Restrictions on the fossil fuel supply could force the world to decarbonize faster. But seizing this opportunity requires investments of foreign capital into EMEs in the short-term; hiking interest rates, in contrast, will actively prevent EMEs from accessing such funding, squandering this potential.
A Globalized Mandate for the Fed
Responding to climate change will force international institutions to fundamentally reshape their priorities. The Fed cannot remain aloof from these changes. Given the importance of international coordination to attenuate environmental inequality, the Fed should heed the calls from the Global South to consider the international implications of its monetary policy.
One of the most powerful such calls comes from the UN Council on Trade and Development. Its 2022 Trade and Development Report calls on “central banks in developed economies to…[rely] on ever higher interest rates” and, more generally, to “reform the multilateral architecture to give developing countries greater fiscal space and fairer say in decision-making processes.” The US government can apply these recommendations to the Fed. While the Fed makes monetary policy decisions autonomously, its guidelines are set by Congress. Congress currently directs the Fed to pursue “maximum employment, price stability, and moderate long-term interest rates.” But Congress can–and should–amend these guidelines to include promotion of international development as another of the Fed’s goals.
Raghuram Rajan, the former Governor of the Reserve Bank of India, has called on the US government several times to do just that. In a paper published in 2016, Rajan argues for a monetary system in which “large country central banks…internalize more of the spillovers from their policies in their mandate and are forced by new conventions on the ‘rules of the game’ to avoid unconventional policies with large adverse spillovers and questionable domestic benefits.” Admittedly, Rajan was criticizing the expansionary policies that the Fed adopted in the wake of the 2008 recession. Nonetheless, the broader theme of his criticism remains relevant for the Fed’s current policy of contraction. The Fed’s mandate can no longer be limited to the US economy. Instead, given its outsized impact on international markets, the Fed must ensure that its monetary policy decisions do not further exacerbate global inequities.
Doing so is not mere altruism; the failure to consider the Global South when making monetary policy decisions may also have spillover effects on the US economy. The 1982 Latin American debt crisis, for example, forced US banks to accept severe haircuts; Citibank alone recognized a loss of $3.3 billion. Further, even with extremely nationalized responses, the Global North can only postpone the effects of climate change. In the long run, warming temperatures are likely to have dire global economic consequences–one estimate puts the gains from limiting warming to 2°C at $17,489 billion per year.
Globalizing the Fed’s mandate will have significant social and economic benefits. Monetary policy decisions made in coordination with the global community can support equitable and sustainable development, mitigating the effects of climate change and ensuring wealthy countries do not monopolize the world’s supply of renewable energy. But if the Fed’s outlook remains nationalized, it risks intensifying inequalities in the world’s distribution of resources, with disastrous effects not just for EMEs, but for the economy of the entire world.