The Federal Reserve’s bid to calm inflation by raising interest rates and withdrawing emergency stimulus programs is gearing up just as the global economy is displaying worrisome signs of weakness, aggravated by the war in Ukraine and covid’s continuing hold on industrial supply chains.
While the Fed is just starting to overhaul the loose monetary stance it adopted during the pandemic, global financial conditions already are tighter than at any time since the 2008 financial crisis, according to a Goldman Sachs index.
Faced with tighter money, war in Europe and fresh supply chain troubles in Asia, global growth may buckle. The Institute of International Finance, an industry group, said Thursday it expects global output to “flatline” this year.
In April, Germany’s closely watched Ifo gauge showed business expectations at their lowest level since the first months of the pandemic. Some analysts predict that Beijing’s harsh covid lockdowns will cause China’s economy to shrink in the second quarter. And the price of copper, a key industrial metal, has sagged 15 percent since mid-April.
“There’s just a lot of evidence accumulating that the global economy is slowing quite significantly,” said Jens Nordvig, chief executive of Exante Data. “It’s not just stocks. It’s fundamental commodities linked to real activity.”
The Fed was late in responding to inflation, which accelerated in the second half of last year. But recent decisions in Washington, London and Frankfurt mark a decisive shift in the global economic climate.
To support the pandemic-ravaged economy, Fed Chair Jerome H. Powell and several of his counterparts two years ago reprised the innovative monetary policies introduced after the 2008 financial crisis. They held interest rates near zero for several years and bought large quantities of government and mortgage-backed securities in an unusual intervention in financial markets aimed at spurring growth.
Now, faced with the highest inflation in decades, central bankers are changing course. The end of the easy-money era has caused investors to reevaluate what stocks, bonds, commodities and currencies are worth, and that is buffeting a global economy already weathering war and disease.
The result is an unusually demanding environment with little margin for error. Powell acknowledged the challenge this month, saying the various forces weighing on the economy today “are really different from anything people have seen in 40 years.”
Since late last year, when the Fed began signaling a tougher anti-inflation stance, global stocks have lost more than $22 trillion in value, according to a Bloomberg index. Investment-grade corporate bonds — those issued by blue-chip companies such as Home Depot or Toyota — have fallen 13 percent this year. The dollar, meanwhile, has soared, nearing a two-decade high while bitcoin has crumbled to less than half what it was worth in early November.
“This is a very dramatic change. We’re returning to a more normal environment, which may not seem very normal to many, because we’ve been mired in this ultra-low-rate, experimental monetary policy for so long,” said Kristina Hooper, chief global market strategist for Invesco. “The adjustment period can be quite painful and ugly.”
The Fed this month raised its benchmark lending rate by half a percentage point — its largest such move in 22 years — and said it would begin unwinding its $9 trillion stockpile of bonds in June. One day later, the Bank of England hiked its key lending rate for the fourth time since December. And on Wednesday, Christine Lagarde, the president of the European Central Bank, said the ECB will halt its bond-buying in July and then move toward ending eight years of below-zero deposit rates.
More upheaval lies ahead. The Fed’s latest financial stability report, released this month, noted investor fears that global monetary tightening “could cause strains in corporate and sovereign debt markets.”
A striking sign of the end of free money is the near-disappearance of lending that involves something less than full repayment.
In the low-growth years after the financial crisis, many investors chose to park their money in bonds that offered small negative returns rather than put them in riskier investments.
Last year, nearly $17 trillion in bonds offering a negative return — meaning bondholders would receive less than their initial investment when the bond matured — traded on global markets.
But as central banks began normalizing monetary policy in the past several months, negative-yielding bonds dwindled to just $2.3 trillion, the lowest total in almost seven years.
In the United States, meanwhile, inflation-adjusted long-term bond yields have jumped sharply in the past two months and are now in positive territory for the first time in roughly two years. Those fatter yields offer an alternative to riskier stocks, helping explain Wall Street’s poor performance in recent weeks.
Some economists worry that — after being late to tackle inflation — the Fed now risks hitting the brakes too hard at a time when the global economy looks weaker than it did just a few weeks ago.
“The speed of the move in this global context makes me quite worried,” said Robin Brooks, chief economist for the Institute of International Finance. “...The situation here is super fluid. We have so many sources of instability in the global economy at the moment.”
Just the anticipation of Fed rate increases sent mortgage rates climbing late last year. Rates on 30-year mortgages were below 3 percent as recently as August, supporting both home-buying and a surge in loan refinancings that gave consumers more spending power.
Now, mortgage rates exceed 5.5 percent for the first time since 2008, according to Bankrate. Those higher rates helped drive the number of home loan refinancings in the first quarter down 45 percent from the same period last year.
“The recent refinancing boom is effectively over,” the Federal Reserve Bank of New York concluded in a May 10 blog post.
The housing market is one sector that will feel the Fed’s sting as it tries to corral 8.3 percent inflation, near a 40-year high. Tighter money also will make it harder for companies to raise money to fund expansion or new hiring.
Less creditworthy corporations, including Twitter and Royal Caribbean Cruises, already need to offer bondholders higher yields than they did just a few months ago. Investors now demand an extra 4.4 percentage points in yield to buy junk bonds rather than ultrasafe U.S. Treasurys, up from 2.8 percentage points in January.
That’s made it tougher for companies like Carvana to raise money. In April, the used-car retailer had to offer investors a 10.25 percent return to sell $3.3 billion in junk bonds, more than twice the yield it offered when it raised money last year.
After spending most of 2021 insisting that inflation would prove temporary, the Fed has plenty of tightening ahead of it. But even as he races to catch up with rising prices, Powell insists U.S. growth prospects remain “solid.”
A strong labor market, with roughly two job openings for each jobless worker, and steady business and consumer spending mean that nothing “suggests that [the U.S. economy is] close to or vulnerable to a recession,” he said at a May 4 news conference.
“The global economy is probably more vulnerable and more exposed to a range of shocks than the U.S. economy is,” said Nathan Sheets, global chief economist for Citigroup.
To be sure, not all central banks are tightening. In Japan and China, policymakers are still trying to goose their economies. Worries about slowing growth are particularly acute in Beijing, where the government’s rigid anti-covid stance is disrupting manufacturing and global supply chains, raising doubts about reaching this year’s official growth target of 5.5 percent.
There are differences among major central banks in the pace and extent of tightening. The Bank of England, which expects inflation to hit 10 percent this year, began raising rates in 2021 even as the Fed stood pat, and started shrinking its bond portfolio in March, three months ahead of Powell’s timetable.
The ECB, on the other hand, has been slower to act and now faces additional complications following Russia’s invasion of Ukraine.
But the central banks that are acting share a common challenge: to crush inflation without smothering economic growth.
Higher U.S. interest rates, which have contributed to the dollar’s 9 percent rise this year, will make themselves felt beyond U.S. borders.
The more muscular greenback will make U.S. imports less expensive, thus helping to cool inflation. But it will make products, including key commodities such as oil and wheat, more expensive for other countries to buy in global markets.
“The Fed is trying to squeeze inflation out of the U.S. The spillover effect is they’re squeezing inflation into the rest of the world,” Freya Beamish, head of macro research for TS Lombard in London, said last week on a webinar.
The stronger dollar also could draw money away from some emerging markets, confronting some with a painful choice between raising their own interest rates, at the cost of a potential recession, or watching capital flee.
Over the past two months, investors withdrew nearly $14 billion from emerging markets, including China, according to the Institute of International Finance.
Tighter global financial conditions could set off debt and banking crises in some developing countries, the International Monetary Fund warned last month. Most at risk are countries that borrowed heavily to fund pandemic relief measures and countries where local banks hold sizable amounts of their government’s debt, such as Pakistan, Egypt and Ghana, according to the fund’s latest global financial stability report.
Government debt accounts for about 17 percent of emerging markets’ bank assets, raising the danger of what the IMF calls a “doom loop.”
As higher U.S. rates draw capital from emerging markets, local currencies depreciate and government bonds lose value. That forces local banks to pull back on lending, weakening economic growth, the IMF said. In the worst cases, such as Argentina in 2001 and Russia in 1998, governments may default on their debts.