Europe Interest Rate Hike: Will the Fed Be Forced to Follow?

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Ben Bernanke: How long can he wait? (Jonathan Ernst/Reuters)

Central banker see. Central Banker do? We will see.

On Thursday, the European Central Bank for the first time in nearly three years raised interest rates. Even though the rate is only going from 1% to 1.25%, it’s a  significant move because the ECB becomes the first central bank among so-called wealthy nations to raise interest rates since the beginning of the financial crisis. And it’s a major shift from just six months ago, when central bankers around the world seemed to be doing anything possible to lower the value of their currencies, in order to make their countries’ products cheaper to the rest of the world and boost growth. And that meant keeping interest rates low.

But that was before this year’s rapid rise in food and other commodities prices. That has caused a number of emerging market economies to raise interest rates. China has raised rates a number of times. And now Europe. So will that put pressure on the Federal Reserve to raise rates in 2011 as well? Perhaps a little. Here’s why:

Interest rates are generally used by central banks to slow and speed the economy. But they can also have significant affects on the value of the local currency as well.

Central bankers can target either inflation or the value of their currency — not both. To drive down the value of money, bankers lower interest rates. But lower rates typically lead to higher economic growth, an influx of foreign capital and, potentially, inflation. The biggest sufferers may be workers in poor countries. Barry Eichengreen, a professor of economics and political science at the University of California, Berkeley, worries that if developing nations continue on their current course, we are likely to see wage disputes and riots. “Workers get angry when wages don’t keep up with prices,” says Eichengreen.

So when the ECB raises interest rates that should cause investors to flock to the euro and therefore cause the dollar to fall. Inflation and the exchange rate of your currency aren’t exactly the same thing (inflation is really when internal prices rise), but a falling currency can cause some inflationary pressures.

The real thing to worry about in the wake of the ECB rate hike is oil, as Colin Barr is good to point out on Fortune.com. Barr says that the Europe rate hike could equal $4 a gallon gas.

It’s worth noting what happened the last time Trichet went down this road. In June 2008, he surprised markets by announcing plans to boost the ECB’s main lending rate to 4.25% from 4%.

The move came at a time when the Fed was already cutting U.S. rates, weakening the dollar. The ECB move sent funds surging into both the euro, as the major currency offering the best interest rates, and into oil, as a commodity hedge against dollar weakness.

The result was a one-day, $16 surge in the price of Brent oil futures in London, to $138 a barrel, on the way to a ruinous $147 the next month (not to mention an equally stunning post-bust $30 in December 2008).

The issue is that oil is generally priced in dollars. So when the dollar drops in value that usually causes oil to rise in price, and that is a concern. Oil has been been one of the main drivers (pun) of inflation recently. Fed chair Ben Bernanke has said that the oil price spike was probably temporary, but if the dollar drops then oil’s rise will continue.

That being said, don’t expect the Fed to jump to copy European bankers. First of all, a lower currency has positives as well. It boost exports by making our goods cheaper overseas. And with an unemployment rate still stuck at 8.8% we could use all the growth we can get. What’s more, the WSJ’s Real Time Economic’s blog points out that the US has a much bigger output gap, meaning how much more stuff we can create than is being current made, than they do in Europe. And that should keep inflation tame here for now:

Why is the European Central Bank raising rates while the Federal Reserve isn’t? There are a lot of reasons, but one big one: The U.S. has a whole lot more spare capacity — in terms of unemployment workers, idle factories, empty offices and stores — than Europe.

Our output gap is about double Europe? Does that mean we can wait double they can to raise rates, meaning 6 years? Perhaps. The last time we raised interest rates was in June 2006. So we are not that far from hitting the 6 year mark. But certainly Europe’s move today makes waiting until next summer before the Fed get serious about reigning in easy money a little more difficult.

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