May 28, 2023
The global economy is closely watching the actions of the US Federal Reserve and the possibility of a recession, including Europeans and other countries. Despite talk of deglobalization and de-dollarization, the US dollar remains the dominant currency, and financial and trade connections between the US and its key partners, particularly Europe, are still strong.
Last year, the European Central Bank (ECB) initially took a different approach from the Federal Reserve by signaling that it would keep interest rates low while the Fed raised them aggressively. However, concerns about imported inflation from goods invoiced in dollars, such as energy, led the ECB to quickly change course after the euro weakened against the dollar.
Now, the challenge is different. Fed officials have indicated a pause in rate hikes to assess the impact of the significant 5 percentage point increase since early 2022 on the US economy. This might make it difficult for their European counterparts to raise rates shortly afterward, despite persistent high inflation.
The US dollar continues to play a dominant role in the global economy, even as there is talk of it losing its reserve currency status. Moves by countries like Saudi Arabia, China, and Russia to use other currencies in response to the US using the dollar as a weapon have not significantly diminished the dollar’s global dominance. Although its share of official foreign-exchange reserves has decreased, the dollar is still involved in roughly 90% of global foreign-exchange transactions.
The extensive use of the dollar in global trade and financial markets means that higher US interest rates have far-reaching effects on foreign economies. These linkages result in capital outflows from other economies, increased borrowing costs, currency depreciation against the dollar, and higher prices of dollar-denominated commodities in foreign currency terms. Conversely, higher rates in the US slow down US growth and eventually reduce demand for foreign products.
According to research by the ECB, the impact of the Fed’s interest rate increases on Europe’s economy is equal to or even greater than their impact on the US. Fed tightening between 1991 and 2019 had negative effects on the eurozone’s industrial output, stock prices, business loans, inflation rate, and world trade outside the US. On the other hand, the actions of the ECB have minimal impact on the US economy.
The ECB closely watches the Fed’s policy actions and the euro-dollar exchange rate, although it is not a policy target. Other overseas central banks also take cues from the Fed but are also implementing similar measures due to high global inflation caused by common global shocks like the pandemic and the war in Ukraine.
The ECB’s decision to continue tightening its monetary policy will depend on whether the Fed’s actions have pushed the US into a recession. Europe heavily relies on exports, particularly to the US, which have been a source of strength amid the war in Ukraine. If the US falls into a recession, European exports will likely decline, impacting Europe’s growth. However, a US recession would likely weaken the dollar, leading to lower European energy prices and imported inflation. Overall, a hard US landing would make things more challenging for Europe but potentially easier for the ECB.
Despite political pressure to control inflation, the ECB will exercise caution due to Europe’s precarious economic state.
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