The long-awaited move is finally on the loose: The U.S. Federal Reserve (the “Fed”) had shown its intensions to start raising its policy interest rates for the first time since 2008. The “federal funds rate” has been increased by 0.25 to 0.50 percent in December 2015, with hints of further hikes coming in 2016. Just to put this decision in historical perspective, let’s just point out that this rate was on the order of 5.9% over 1971-2015, and climbed as high as 20% in 1980.
The decision to increase the interest rate came after three episodes of unprecedented monetary expansion over the last four years. The Fed had amassed–under the program dubbed with the esoteric name of “quantitative easing”—a total of 3 trillion dollars worth of assets from the finance markets, equivalent to roughly 20% of U.S. GDP.
Earlier this year, in a separate Triple Crisis blog on the Bretton Woods After 70 Years, I shared the outcomes of this massive expansion in liquidity: Interest rates fell all around the globe to virtually zero, but with barely a dent in the real sector. Unemployment barely fell to the pre-recent levels, and gross domestic product in U.S. and elsewhere remained stagnant.
The figure below, borrowed from that earlier piece, summarizes those developments.
Source: US. Bureau of Economic Analysis
The obvious conclusion is that, in the absence of an effective real rise of investment demand, the expansion of monetary base and the collapse of the interest rates have had a negligible effect on the GDP performance. That means that the instruments of monetary policy were virtually powerless in lifting up the U.S. and global economies from the Great Recession.
But then what else does this move imply for the global economy, especially for the developing world?
First of all, let’s recall that the main mechanism of adjustment of the expansion of liquidity globally was severe appreciation of the domestic currencies in the developing world (or “emerging markets,” in the new jargon). This was, no doubt, a direct outcome of the increased hot money inflows into the region. As a consequence, import demands of these countries had exploded and led to current account deficits with intensified external indebtedness.
In Figure 2 below, we can follow the rise of the external indebtedness in the emerging markets. The breakdown of debt shows very clearly an ongoing pattern of growing non-financial corporate debt. The public-sector debt burden, on the other hand, fell as a percentage of GDP, while the private non-financial corporate sector foreign debt has approached 90% of GDP.
The rising foreign indebtedness as a ratio to gross domestic product had been of the key leading indicators of instability and deteriorating macroeconomic fundamentals.
Source: The NEF Blog, “Interest rate decision: the global financial crisis” December, 2015.
The announcement of the increase in the Fed’s interest rates very clearly signal the end of an era of cheap sources of foreign finance. The foreign-debt-driven, speculative-led growth has come to an end. The show is over.
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