But if the US continues to lift rates, and the UK and eurozone are obliged to follow suit to combat the imported inflation from the US, this could mean those central banks having to set an interest rate higher than the neutral rate – that is, a rate of interest so high it restricts growth in those economies.
And with US inflation still far above the Federal Reserve’s 2 per cent rate, rates are likely to keep rising in the US. And higher interest rates themselves can cause the dollar to rise; this is because US investors, if they can get a higher rate on their cash in the bank at home, or from US government bonds, sell their overseas holdings, convert the overseas currency back to dollars and keep the cash at home.
Moëc says this adds to the “downward pressure” on riskier assets.
He adds that: “When the dollar is strong, it not only effectively exports inflation to the rest of the world, it also reduces the spending power of the rest of the world, because of higher commodity prices. It is a negative trade shock for economies as they must pay more for imported goods.”
George Lagarias, economist at Mazars, says the Fed’s policy is “breaking things”, and that while it is focused, naturally, on the interests of the US economy, “it is effectively the world’s central bank, and right now, it is not performing that role”.
External vs domestic factors
Melanie Baker, economist at Royal London Asset Management, says the question being pondered by central banks right now is the extent to which inflationary factors are driven by external factors, such as dollar strength, or domestically driven factors such as government fiscal policy.
Often, a hint about the level of domestically driven inflation comes in the unemployment numbers. As rates rise to combat internationally driven inflation, the expectation would be that jobless numbers would rise.
This has not yet happened to any meaningful extent, but Baker says it is quite early in the cycle to draw any conclusions from that.
Policymakers traditionally try to judge whether an economy can withstand higher interest rates by attempting to measure the output gap.
This gap, whether a positive or a negative number, is the difference between the long-term trend rate of growth an economy can achieve without inflation being a problem, and the actual rate of growth in an economy at any given time.
If the actual rate achieved is lower than the trend rate (what economists would call a negative output gap) then the traditional response of policymakers would be to cut interest rates to stimulate growth.
The UK is presently experiencing a period of negative GDP growth; this means the output gap is negative.
