How Might the Fed’s Rate Hike Influence Global Demand and Investments?

Wed, May 13, 2015 - 8:57am

The upcoming changes in US monetary policy will have strong effects on aggregate demand, investments and public spending worldwide.

On August 9, 2007, BNP Paribas, France’s largest bank, announced a “complete evaporation of liquidity” before freezing $ 2.2 billion worth of funds. Later on, this came to be known as the beginning of the bursting housing bubble in the United States.

Almost 8 years later, and after many changes in financial regulations around the globe, the Central Bank of the United States is deciding when it should finally raise interest rates.

Many analysts agree that with the unemployment rate in the US now at 5.4 percent, a 7-year low, the moment to raise interest rates has finally come.

Last Friday, Wall Street celebrated the US economy giving clear signs of recovery as the Dow Jones climbed up 1.5% by the end of the day. Fed Chair Janet Yellen, however, highlighted that “equity market valuations at this point are quite high,” adding that “there are potential dangers there.”

What will happen in the markets once rates are changed is not easy to predict, but Yellen warned that long-term interest rates could see a sharp jump, causing a disruption across the financial system. She also mentioned risks to financial stability will be “moderated, not elevated”.

But what about commodities? In particular, what will become of assets that don’t pay any interest, such as gold? Gold has experienced ups and downs for the last two months, falling sharply almost 12% between late January and late March. This drop can be interpreted as the expectation of an upcoming change in monetary policy by the Fed.

[Read: Investing in a Rising Interest Rate Environment]

The influence that the Federal Reserve has on the rest of the world is immeasurable, and markets all around will be affected by any changes it makes.

When the Fed finally decides to change interest rates, we will see a sharp appreciation of the dollar due to higher demand of the American currency by investors abroad, who will be acquiring dollars to drive investments to higher yields in the United States.

This increase in the value of the dollar has a hidden impact on emerging markets and commodities’ prices. Importers of American products all around the world will be now paying much more for these goods.

The change could affect growth in emerging markets in many different ways. Money fleeing from around the world to the US will be withdrawn from investments allocated elsewhere, hurting the economy of the country where they are placed. Moreover, this capital flight will make those countries weaker when issuing and repaying debt, given the fact that it will be more expensive to get the dollars they need to pay their creditors.

With regard to commodities, the Fed’s moves might put some pressure on the prices of crops. The expected increase in rates will have an impact on aggregate demand not only in the American market, but also on the prices of, for example, soybeans all around the world.

Due to the higher value of the dollar, soy will be less wanted, ultimately lowering demand of soybeans against other alternatives. This would reduce the price that traders are willing to pay for soy derivatives, no matter where the bean is coming from. This behavior of the market will affect countries like Argentina and Brazil, who rely on their crops and vegetable oil exports to function.

On the other hand, let’s not forget about Europe, which was celebrating having a zero percent monthly inflation rate in April after having periodic deflation for the last 4 months. This followed the measurements that the ECB created to spur demand and public spending, and to support the growth of the job market, all of which were weakened after the financial crisis.

Even though Europe is not an emerging market, it will be affected by the changes in the United States’ monetary policy, which might slowdown EU economies against the intentions of the ECB.

The Central Bank of the US is not only taking measures that ensure controlled inflation and lower aggregate demand within the American borders. Without intending to do so, the Fed is influencing the global aggregate demand of products that are traded in the North American currency.

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