The Fed is driving the world towards recession, or worse

The US Federal Reserve Board’s determination to bring a rampant inflation rate under control is exporting inflation, recession and turmoil in currency and other financial markets to the rest of the world.

The impact of the accelerating divergence between US monetary policy and that of the other major economies is being exacerbated by the energy crisis – particularly acute in Europe – sparked by Russia’s invasion of Ukraine.

The US dollar is the king of currencies.
The US dollar is the king of currencies.Credit:AP

Efforts to blunt the effects of the massive spikes in energy and agricultural commodities – driven by the combination of war and a surge in the value of the US dollar, the result of growing interest rate differentials between the US and other economies – are adding to the fiscal challenges for economies that saw massive splurges in government spending in response to the pandemic.

Adding complexity to the challenges faced by policymakers are the continuing, albeit slowly diminishing, shortages of supply and changes to long-established supply chains that the pandemic induced and which have subsequently been overlaid by the impact of the war and the heightened geopolitical tensions between the US and China.

A poorly received unfunded mini budget in the UK which contained the biggest tax cuts in half a century – a supply-side binge in an economy with an inflation rate last month of 9.9 per cent and rapidly swelling trade and budget deficits – has added to the volatility and sense of crisis.

The British pound plunged to record lows against the US dollar this week amid a brutal sell-off of UK bonds. In the past week, the yield on 10-year UK government bonds has shot up from 3.13 per cent to 4.24 per cent. At the start of this year, those bonds yielded less than one per cent.

Chancellor Kwasi Kwarteng’s mini budget will cost about £291 billion ($A483 billion) over the next five years, or more than 12.5 per cent of the UK’s gross domestic product.

It will impose enormous pressure on the Bank of England to raise interest rates more aggressively than it might have envisaged to combat the increased inflationary threat posed by the spending binge, defend the pound and avert the threat of a balance of payments crisis.


In some respects, the UK’s plight reflects the dilemma confronting many policymakers, caught between a surge in inflation to levels not experienced for decades and shrivelling economic growth rates. Europe, most impacted by the energy crisis, is destined for recession even as the European Central Bank raises eurozone interest rates.

It’s not just Europe or the UK, however, where the after-effects of the pandemic and the Fed’s relatively newfound aggression are biting.

As discussed yesterday, the Bank of Japan was forced to intervene in the market for the yen late last week for the first time in nearly a quarter of a century after experiencing a 20 per cent drop in the value of its currency against the US dollar this year.

This week, the People’s Bank of China fixed the value of its currency at more than 7 yuan to the US dollar for the first time since the worst moments of the pandemic in 2020. The yuan started this year at 6.35 to the dollar.

While China doesn’t have an inflation problem it does have a growth problem. Most recent forecasts see China’s GDP growth rate being revised down below three per cent. The effects of its COVID-zero policy, a property crisis, high energy costs, and the fact commodity costs are inflated by being traded in US dollars, are combining to throttle the economy.

The slowing growth and depreciation of currencies in the two biggest and most interconnected economies in Asia will spread economic pain beyond their borders.

And it’s not just Asia where the effects of inflation, rising interest rates, energy and food costs and currency depreciations are being experienced. Eastern Europe (largely because of the war), Africa and South America are also in trouble and the list of sovereign defaults is growing.

It is a messy and potentially dangerous environment; one that has reduced the value of all risk assets and even some, like government bonds, regarded as safe havens.

While the less developed economies in the region are less exposed to US dollar-denominate debt and have greater foreign exchange reserves than they had in the lead up to the Asian financial crisis of the late 1990s, there is capital flight occurring as investors are lured away from the region towards the higher yields and currency appreciation proffered by the US.

In Europe, the euro broke through parity a week ago and is now trading at 20-year lows of around 96 euros to the dollar. European policymakers are in an invidious position, with eurozone inflation running above 9 per cent but economies being ravaged by the exorbitant cost of securing energy supplies ahead of winter.

The powerhouse eurozone economy, Germany, is shrinking because its economic model – manufacturing powered by cheap Russian gas – appears irreparably broken.

The Fed is still a long way short of where its terminal rate – its peak policy rate – is expected to be. The federal funds rate now lies in a range of 3 to 3.25 per cent. The Fed’s own projections are for it to reach about 4.6 per cent next year.

Couple the pace at which the Fed is now moving with America’s traditional role as the safe haven in volatile times and there is a prospect of continuing capital flows towards the US and away from other economies and therefore continuing downwards pressure on other currencies and upward pressure on their rate structures.

If the Fed does continue to hike aggressively they will be under immense pressure to play catch up or face further significant depreciation of their currencies and an increase in inflationary pressures.

The Australian dollar for instance, traded just under US65¢ on Monday. It peaked at just under US76¢ in April and was still above US70¢ in the middle of last month. The RBA will have no option but to factor in the inflationary effects of that depreciation in its future decision-making.

It is a messy and potentially dangerous environment; one that has reduced the value of all risk assets and even some, like government bonds, regarded as safe havens. Equities and bonds are in bear markets triggered largely by the surge in US interest rates.

The OECD downgraded its forecasts for global growth on Monday, saying the global economy would still achieve three per cent growth this year but slow to 2.2per cent next year. It blamed the war in Ukraine for the slowing growth and upward pressure on inflation.

In the complex and darkening circumstances those would be acceptable, if unpleasant, outcomes. The risks, however, remain, as the OECD noted, tilted to the downside and the prospect of something worse – some form of global financial crisis – looms while the Fed keeps tightening US monetary policy faster than its peers and interest rate and currency relativities continue to diverge.

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