Apparently, the worst has passed for the biggest economies of the world, and recovery has begun. The global recession “is ending,” according to the latest World Economic Outlook from the International Monetary Fund (IMF), released on October 1 in Istanbul. The IMF raised its global growth forecasts due to the strength of Asian economies, and cited positive signals from other regions. The organization explained that the advanced economies, shaken to an exceptional degree by the financial crisis and the collapse of global trade, now show “signs of stabilization” thanks, in large measure, to “an unprecedented political response.” Inevitably, given these signs of optimism, investors around the world have begun to ask: Now what? The question on their minds is whether it is time for central banks to raise interest rates, which have been at abnormally low levels.
The world’s main central banks – the U.S. Federal Reserve, the European Central Bank (ECB) and the Bank of Japan – are in a delicate position. If they raise interest rates too early, they may stymie the recovery now under way, choking economies once again. But if they wait too long to raise rates, they could generate inflationary pressures and create bubbles.
Discrepancies at the Fed
In the U.S., after a year of near unanimity about what direction to pursue, the bankers running the Federal Reserve seem to be divided about what to do next. In December 2008, the Fed lowered interest rates to 0.25% and its Federal Open Market Committee (FOMC) – which sets monetary policy – said at its latest meeting in late September that economic conditions would warrant keeping rates “at an exceptionally low level for an extended period.”
But not everyone is in harmony at the Fed. On October 6, Thomas Hoenig, president of the Kansas City Fed — one of the 12 regional legs of the central bank — supported the idea of raising the benchmark rate soon, asserting that even rates of 1% to 2% would be "very accommodative” as opposed to tight monetary policy. Given the imminent rotation of regional Fed managers, Hoenig will become one of the members who has voting rights on the FOMC next year. His view clashes with that of Ben Bernanke, president of the Federal Reserve, who said on October 9 that he was not in a hurry to raise rates.
What will happen next? “I believe that we will see a rate increase coordinated by the principal central banks of the world,” notes Rafael Pampillón, professor of economic analysis at IE Business School in Spain. “We are facing a very delicate situation when it comes to currency exchange rates, with the dollar depreciating a great deal lately. If the ECB were to raise interest rates, it would be a very harsh blow for the U.S. currency.” If there were not a coordinated rise, he says it would be “advisable if the Fed were the first to raise rates to help the depreciated dollar.”
In any case, Pampillón doesn’t expect higher rates soon. He says the world’s principal economies, in addition to facing growing public-sector deficits, “are suffering a significant excess in productive capacity.” Against that backdrop, “it is hard to generate a significant increase in inflation.” In addition, he argues that before raising rates, “governments have to withdraw their fiscal stimulus measures, just as central banks [have to withdraw] their extraordinary measures for injecting liquidity into the markets.” He adds, “I don’t believe that the ECB will raise rates until the end of 2010 or the beginning of 2011 because [economic] conditions are very delicate.”
F. Xavier Mena, professor of economics at ESADE Business School in Spain, predicts that the economies of the U.S. and Germany will be the first to emerge from the crisis. He adds, “The central banks will be pressured to raise interest rates even before they glimpse the first signs of credible recovery because they don’t want to end up [repeating] the mistakes [central bankers] made at the beginning of the century when they lowered the price of money a great deal, and they kept [the low rates] for too long when the recovery was already strong, which led to a series of economic bubbles.”
According to Mena, the United States “will not be late” when it comes to raising rates. “It may take some time, but I believe that we can measure the delay in terms of months, even weeks” before [the U.S.] “starts to normalize rates and bring them [back up] to 1%.” He predicts that within about a year, rates could be "completely normalized in the U.S. and a little later in the euro zone.” (By “normalization” Mena says he means rates being at about 4%, an “appropriate level so that inflation does not shoot up during a period of [GDP] expansion.”)
Cause and Effect
Higher U.S. rates will inevitably have consequences in Latin America. David Robinson, deputy director of the IMF’s western hemisphere division told reporters in Istanbul in October that Latin American countries must have a higher cost of credit when they emerge from the global recession, which will make it harder for them to stabilize their debt levels.
Robinson explained that based on past experience, for each 10% increase in U.S. debt as a percentage of GDP, the cost of credit in the region rises 15 basis points. This will make it harder to implement the fiscal adjustments needed to stabilize debt levels, which are already “quite high,” he said. “Part of that will occur naturally, to the degree that the recovery takes place. But many countries will also have to undertake significant adjustments, and obviously this will be complicated if there is a lower [rate of] external growth and if interest rates abroad are higher.”
According to Pampillón, increasing rates in the U.S. would cause a depreciation of Latin American currencies against the greenback. That would mean “an increase in [Latin American] exports and an increase in the value of dollar remittances coming back to these countries [from Latin Americans working in the U.S.]” However, the dollar’s appreciation would also have negative consequences, because “the burden of [Latin America’s] external debt, denominated in dollars, would be greater.”
He adds that the interest rate moves made by various Latin American economies will depend more on their inflation levels than on the direction followed by U.S. monetary policy. “These are economies that have suffered less from the crisis [than developed countries] because they don’t have as much idle productive capacity and their inflationary pressures are greater. Based on these arguments, central banks in the region will be more tempted to raise [interest] rates.”
Mena concurs that Latin American economies “have been more immune to the crisis than other countries have, and … have suffered less than during previous crises.” Any appreciation of the dollar resulting from the Fed raising U.S. rates would be harmful to economic activity in the region. However, “the rise in the [value of the] greenback would have to be very large to create any significant damage [in Latin America],” and that sort of rise is not something he expects. As such, he says, “I don’t see any bad prospects for the region.”
Mena predicts that Latin America’s central banks will follow the same path of the big global economies, and they, too, will raise rates. However, he affirms that this would have to happen one country at a time, in a region that is not "at risk economically.”
The ECB’s Difficult Assignment
Meanwhile, the ECB, which kept interest rates at 1% on May 1, could face a difficult dilemma in coming months. Europe’s economies are emerging from the recession at an uneven pace, which means that they need different monetary measures.
Germany and France, the two largest countries in the euro zone, emerged from recession in the second quarter of the year, reporting growth rates of 0.3% on a quarter-to-quarter basis. According to the latest forecasts of the European Commission, these countries will continue recovering in the next quarter and will grow 0.2% in 2010.
Spain and Ireland are in a different situation. This year, according to the Commission, their economies will contract 0.9% and 1.5% and record some of the region’s highest budget deficits at 9.8% and 15.6% of their GDPs, respectively. The European Commission says Spain will be the only country among the largest EU economies that will continue to contract in the fourth quarter of this year.
Jean-Claude Trichet, president of the ECB, will not be signaling a need to adjust monetary policy. He has said on numerous occasions, “If we judge that the nonstandard measures trigger risks to price stability, we will unwind them.” Nevertheless, Bank of America-Merrill Lynch and Morgan Stanley predict that rate increases will begin at the latest by June 2010, according to Bloomberg.
Is history repeating itself? “The ECB will not take into consideration the condition of countries like Spain and Ireland. They didn’t consider them after 2001, when those countries needed higher rates and Germany, France and Italy needed lower rates, nor will they do so now when the opposite situation exists,” says Pampillón. “We are seeing a remarkable divergence in the economic cycles of some countries in the euro zone. Spain needs lower rates for a longer time, while Germany and France need higher rates because, extraordinarily, they are recovering from the crisis before the United States is.”
According to Mena, if the ECB wants to be seen as independent, "it will not be affected by political pressures.” Yet he predicts that the bank “will indeed raise rates,” due to the large combined economic weight of Germany and France. “If they recover, half of the economy of the region recovers; so in this context, there is nothing else to do but raise rates.”
If the ECB raises rates, he adds it would be a “mortal” blow to Spain, and the “coup de grace” for its damaged economy. In this context, some experts, such as Paul Krugman, the Nobel Prize-winning economist, have argued that it would be good for countries such as Spain and Ireland to leave the euro zone. However, “the cost of abandoning the single currency would be greater than that of maintaining it,” notes Pampillón.
Mena agrees that it would be harmful to Spain if the ECB raised rates and that abandoning the euro would be a very bad way for the country to solve the problem. “There are two clear reasons for keeping the single currency. The first is that a devaluation of the peseta [the Spanish currency before the country adopted the euro] does not guarantee an increase in [Spanish] exports and therefore [it does not guarantee Spain’s economic] recovery. The second is the sizable [public] debt, which would increase even more [if Spain returned to the peseta] because of the risk premium that it would have to pay to investors as a result of the depreciation of its currency,” Mena says.