How Fed Rate Cuts Affect The Global Economy

The Federal Reserve is the world's largest central bank. The fed is important to the global economy in so many different ways. The US is the sort of the locomotive of the global economy.

Even though other central bankers often say that they don't follow the fed. They often implicitly have to. The Fed's leaders see a slowdown coming in the US job market.

The time has come for policy to adjust. The time has come for policy to adjust. Since the quote that's been heard around the world.

Those changes can alter how much dollars are worth in the United States and beyond. There's a huge trust factor, and therefore the dollar is seen as the world's reserve currency. So how did the fed become the world's most powerful central bank, and what do its upcoming decisions mean for the global economy?

The US economy, guided by the fed, is the largest in the world. The US economy's stature is one of the key drivers of the importance of the fed. Given that the US economy remains one of the largest economies in the world, and certainly of late, one of the ones that's been fastest growing.

A country and its currency doesn't become important and the world's most important currency overnight. The value of the currency depends a lot on the economy. If the economic conditions are right, there's economic growth in the region.

Then the currency will also appreciate and do well. From 2022 to 2023, interest rates controlled by the fed rose to over 5%. Many central banks around the world did the same, making loans more expensive and slowing economic development to halt a global bout of inflation.

Everybody took the elevator on the way up. Tightened monetary policy very rapidly. The fed was at 5.

5%. Most other central banks were either close to or slightly lower to the Fed's policy rate. Certainly, across advanced economies.

Higher interest rates can increase the value of cash. If interest rates are high relative to other countries, the dollar is appreciating. Higher interest rates also make it more difficult to receive raises at work.

This can prevent escalating bouts of inflation that economists call wage price spirals. The fed has managed the currency for a long period of time in a way that is supportive of a strong dollar, so they will tend to cut off any threat of wage price spirals. And they've done that for a long period of time.

The Federal Reserve manages those interest rates based on what they see as happening in the labor markets and inflation. By the end of summer 2024, signs of an economic slowdown appeared in the US, prompting central bankers to consider reductions in interest rates. As the fed lowers its rate, it's going to get closer to other central banks interest rates.

Changes to the Fed's interest rate can disrupt stock market trading techniques, too. And that's really what we saw in early August, where we had. This.

Sudden global market sell off that initially started off of a weaker than expected payroll report in the US. The cooling in labor market conditions is unmistakable. We still have job growth that was positive.

We had a slight increase in the unemployment rate. What happened was that it was weaker than expected. The weak labor data led investors to abandon a popular strategy called the carry trade.

Here's how it works. You borrow in a currency that is that is cheaper, undervalued, and then you invest in a higher yielding currency. For example, an investor might borrow money in Japanese yen to buy US assets like the ten year Treasury bond.

When a carry trade is working well, that means the value of my my dollar assets that I've just purchased are appreciating compared with my my yen borrowing that I've used to finance the trade. But that strategy can backfire. If the fed is is all of a sudden expected to cut more than people were expecting?

That can start to depreciate the dollar. So if one central bank cutting interest rates, the fed and another central bank is raising interest rates. The Bank of Japan.

It leads to a weaker dollar and an appreciation in the yen. You have this spread delta between policy rates. That is narrowing.

The unwinding of those technical positions can actually exacerbate some of the movements in foreign exchange currency. So it's not just about sort of a small shift in expectations, but that small shift in expectations can be magnified into a really big move. The Fed's mandate is a US based mandate.

So the fed is going to do whatever makes sense for the US. But obviously the fed is also keeping the global economy in mind. The rate cuts also affect financial conditions in many parts of the world.

Why is the fed followed so broadly internationally, globally? Because the actions of the fed, Federal Reserve Board, they're not just limited to the US, they have a spillover effect in other parts of the world. Also, there's some saying that when the US sneezes, emerging markets catch a cold.

The tightening of financial conditions, particularly in the US, has been one of the major concerns for emerging markets. If we think we're on the precipice of of non recessionary rate cuts in the US, some of those capital flows can start to reverse and that can be a boon for for emerging market policy makers. And some countries are dollarized.

So those countries will feel an even bigger impact on. The world's use of dollars gives the fed some additional influence in times of crisis. There are strong inter-linkages financial linkages, and in today's very interconnected world, those types of movements occur very rapidly.

The pandemic was a notable example. The fed was sending money to other countries using their so-called swap lines. The introduction of the swap lines has really restored dollar funding markets around the world to fairly normal levels of activity.

Swap lines are temporary loans sent from one central bank to another. For example, the Bank of Japan had $225 billion in outstanding withdrawals from its swap line with the Federal Reserve at a point in 2020. The fed provides those loans to a select group of international authorities to ensure that disruptions abroad don't create problems back in the States.

It's a great tool during periods of financial crisis, to know that the fed is there, willing to provide dollars when the global economy needs it. In a way, it's an insurance. If the ECB needs dollars, what are their options?

They can go to a swap line, or they can sell the US Treasury securities that they own. You'd rather not have everybody selling their US Treasury securities because they need dollars. You'd rather have some other option available to them, like a swap line.

The use of swap lines can halt rapid swings in the value of dollars and other currencies. If you look at global foreign reserves, if you look at foreign exchange trades, all of those trades are done mostly in US dollars. And wherever there is another currency, its share is relatively minimal.

When they were used in the pandemic, swap lines were responsible for nearly 20% of the increase in the Fed's balance sheet. Other economic heavyweights like the European Central Bank and people's Bank of China offer swap lines, too. China has extended swap lines to about 40 central banks, but some researchers believe this network is primarily used by countries who have difficulty borrowing in international markets.

China does have its own swap lines, and it has built a very broad network that is completely in parallel to the dollar system that we all have been relying on for several decades. Swap lines with other countries wouldn't be that effective. But coming from the fed, it goes a long way.

In helping other countries have attempted to avoid the prominent US dollar with strategic monetary policies, most notably in China. In every single sector now, we're seeing Chinese companies really compete and win. It's not Nike or Adidas, you know, it's it's Li Ning and other companies in China.

We know this story. It's BYD, it's not Tesla. The flood of EVs that we see coming out of China is a direct result of the fact that China has become debt saturated and can't use its previous growth model to just increase investment, increase leverage.

If they're following this growth model, then they have to rely more on on exports. At the same time, the other side of the dichotomy is that they want to internationalize the renminbi. The renminbi is also known as the Chinese yuan.

This currency accounts for 4. 3% of payments made globally that shares rising, but it's far behind the use of dollars or euro, according to the Federal Reserve. It doesn't take off by itself because China lacks the sort of the natural economic reasons why you would want to sort of hold in that currency, but it starts to take off when when the dollar becomes weaponized, as it was against Russia.

I think another thing I'd say that's happening is this movement towards central bank digital currencies. Yuan is an example of that. Can any of these replace the dollar?

Certainly not in the near term. But at the same time, I would say dollar assets used to be somewhere about 70%. And they've declined from 70% in 2000 to now 60%.

So you see some chipping away happening. But I always come back to what is the alternative. Who's the heir.

And I don't think there is any apparent heir to to the throne right now.