Monetary policy Fear overwhelmed investors as the US Federal Reserve announced its intentions: How interest rate hikes affect stocks, currencies and the eurozone

Of the United States the central bank begins tighten monetary policy almost certainly this year, but in the euro area a similar one is not in sight this year.

There is nothing miraculous about differentiation per se. Following the intensification of the financial market crisis in 2008, the US economy has been clearly stronger.

The US Federal Reserve tightened monetary policy nine times between 2015 and 2018 by 0.25 percentage points. The European Central Bank’s (ECB) deposit rate for commercial banks, on the other hand, has been negative since 2014.

After the worst phase of the coronavirus pandemic, the recovery in the United States has been stronger than in the euro area. Inflation has also accelerated markedly and more broadly.

The divergence in monetary policy may raise the question of the consequences of rising interest rates in the United States this year but remaining unchanged in the euro area. The consequences are likely to be greatest in emerging economies.

Stocks

Why are stocks going down at all when the central bank raises its key interest rate?

Simplified, there are three main reasons for this: the present value of future returns on equities is declining, corporate financing costs are rising and fixed income investments that investors consider safe are becoming more attractive.

Shares fell on Wednesday as the Governor of the U.S. Federal Reserve said Jerome Powell did not rule out raising the policy rate more often than expected this year. In the past, the central bank has hinted that it will tighten monetary policy three times this year.

On Wednesday, some investors estimate that the central bank will tighten monetary policy five times this year after the governor said in a statement. It would very likely lead to a significant slowdown in inflation, but in the worst case scenario would jeopardize economic growth and could cause significant instability in securities markets.

Currencies

Research Director of the financial company Danske Bank Heidi Schauman estimates that the dollar will strengthen gradually, but not dramatically, due to monetary tightening.

For emerging economies, the strengthening of the dollar could cause problems, as many of them have abundant dollar-denominated loans. As the dollar strengthens, the value of loans will increase in the domestic currency.

“The vulnerability of emerging economies is a real problem. In any case, the economic recovery is already slower and, due to the strengthening of the dollar, the financing costs of the states will increase, which will exacerbate their predicament. ”

Professor of Economics at the University of Helsinki Niku Määttänen agrees with the vulnerability of emerging economies, which also have relatively high levels of dollar – denominated loans to businesses and sometimes to households.

“The tightening of monetary policy in the United States is likely to weaken the exchange rate of these countries against the dollar, which will support their exports. On the other hand, the weakening of the domestic currency is easily a problem for those who have dollar-denominated debt but still have income in their own currency. ”

For the euro area, the strengthening of the dollar is basically a good thing, as the relative price competitiveness of companies in international trade is improving. On the other hand, the weakening of the euro is likely to accelerate inflation as euro-denominated products become more expensive in the euro area.

“In my opinion, the slight improvement in the price competitiveness of export companies and the importance of the rise in the price of goods purchased in dollars are relatively small in this overall situation,” says Määttänen.

Euro area

In the United States, rising consumer prices, or inflation, are clearly stronger and more extensive than in the euro area. Therefore, there are already signs in the United States that wage earners are demanding large wage increases.

Large wage increases will lead to rising labor costs for companies. For this reason, companies have to raise the prices of the goods and services they sell in order to ensure profitability, which in turn accelerates inflation.

“The biggest risk in the euro area is that wage pressures will increase more than expected due to accelerating inflation. I think it is possible that the US Federal Reserve is better off on this issue than the ECB, ”says Schauman.

He also points out that in the United States, data on wage developments are available on a monthly basis, but in the euro area on a quarterly basis.

“There is a single labor market in the United States, while there are several labor markets in the euro area that are developing at a slightly different pace. From the point of view of the central bank’s monetary policy, this divergence is a problem for which it cannot do anything. “

On the market the ECB is expected to tighten monetary policy as early as this year. The general manager of this Christine Lagarde has so far rejected many times. He has stated that changing interest rates this year is very unlikely.

Schauman emphasizes that the ECB’s monetary policy must take into account the cost of borrowing for the euro area, even if this is not ‘officially’ acknowledged.

As eurozone government bond purchases are phased out and monetary policy tightened, government financing costs will rise. In this case, the countries with the heaviest debt burdens are in particular.

If financing costs rise rapidly, governments tend to reduce their public spending in order to strengthen market confidence in their ability to pay and to obtain loans on more favorable terms.

“For the major eurozone countries, this may be a key issue in heavily indebted Italy in the near future; how it will succeed in winning the confidence of the market after the central bank no longer supports its funding with its securities purchases. ”

What about has the ECB failed in its priority of 2% inflation over the medium term?

According to Professor Määttänen, at least there are no signs of failure yet, as inflation in the euro area has been slower than the central bank’s price stability target for years.

“When the ECB could no longer lower key interest rates, it sought to strengthen inflation expectations by implying that interest rates would not be raised as soon as inflation accelerated. For these reasons, I think it is justified for the ECB to now allow inflation to be momentarily higher than the medium-term objective. It is still important that the central bank is ready to react if inflationary pressures do not seem to ease any time soon. ”