The Federal Reserve is expected to raise interest rates another three quarters of a point this week in its effort to bring down inflation, further increasing the strength of a rapidly rising dollar in the process.
That’s increasingly being seen as a problem in Europe, where concerns about a recession are growing as currencies lose power to the U.S. dollar.
Europe is also dealing with economic pressures from Russia’s war on Ukraine, with mounting fear that Russian President Vladimir Putin could use energy as a potent weapon this winter. Many European countries depend on supplies from Russia to heat homes over the winter.
The worries are leading to new complaints from those who see the Fed’s actions as potentially causing more problems than they will fix if Europe takes a serious hit.
“This is my real frustration with what the Fed is doing now. Frankly, the global geopolitical economic conditions don’t justify 75 basis points,” Claudia Sahm, a former Federal Reserve economist and founder of Sahm Consulting, said in an interview with The Hill.
“Our monetary policy is crushing Europe and emerging markets. The Fed is almost certainly making the hardship in Europe worse,” she added.
Rising interest rates make it more expensive to borrow money and effectively make the U.S. dollar more valuable compared to other currencies.
The euro is down about 12 percent on the year compared to the dollar, reaching a one-to-one ratio, the weakest level in about 20 years. The British pound is down more than 15 percent on the year to its lowest level since the mid-1980s.
The Japanese yen is down 20 percent compared to the dollar, the Chinese renminbi is down about 9 percent, the Indian rupee about 7 percent and the Swiss franc about 5 percent.
The changing values of the currencies have a number of real-world effects.
The dollar goes farther for U.S. travelers abroad, but it makes it more expensive for U.S. manufacturers to export goods. It reduces costs for U.S. importers at a time when supply-chain problems related to the coronavirus and high demand emerging from the pandemic have helped fuel inflation.
The international knock-on effects of a strong dollar are not likely to be at the top of Fed’s current list of priorities. Getting a handle on 40-year-high inflation, which was initially mischaracterized by Fed economists and Treasury officials as “transitory” and not a serious cause for concern, is more pressing.
The Fed may even view an artificially strong dollar as a good thing in the short term because it’s favorable to U.S. consumers despite forcing global economies to recalibrate their import and export dynamics.
But a major recession in Europe, where central banks are also raising interest rates to fight inflation, is not in the interest of the U.S., which is one of Europe’s biggest trading partners.
Domestic producers have also been hit hard by the strong dollar and are keen to see exchange rates level off in the interest of selling more goods overseas. More interest rate hikes by the Fed will continue to undercut bottom lines in the U.S. manufacturing sector.
But the Fed is conscious that inflation is sensitive to higher import costs. Recent research from the New York Fed showed that high import prices due to backed-up supply chains were a major reason behind the rising prices felt by U.S. consumers in the pandemic’s aftermath.
Price increases passed on to domestic producers from higher import prices “more than doubled during the Covid period,” according to a study published in August by the New York Fed’s Liberty Street Economics blog.
Europe is in a particularly difficult spot because of the Russia-Ukraine war, which shows little sign of slowing down despite advances in recent weeks by Ukraine.
Faced with a barrage of Western sanctions that now include a price cap on Russian energy exports, Russia halted its natural gas supplies to Europe at different times over the summer, citing maintenance issues with a major pipeline.
European authorities reacted by implementing new energy regulations to bring down “astronomic” electricity prices while moving their economies away from formerly cheap and abundant Russian natural gas.
In the United Kingdom, the government increased its price cap on household energy expenditures by 80 percent for October as the country deals with soaring energy prices.
“We are supporting this country through this winter and next, and tackling the root cause of high prices, so we are never in this position again,” British Prime Minister Liz Truss said in a statement on the energy crisis earlier this month.
Elsewhere in Europe, countries cut their economic growth forecasts, with Finland bringing down its gross domestic product estimate for 2023 to 0.5 percent from a previous estimate of 1.1 percent.
“Rising prices are hampering Finland’s economic growth,” the country’s finance ministry said in a Monday statement.
“Finland’s GDP will increase 1.7 percent in 2022, though growth will slow considerably towards the end of the year. The increase in consumer prices has accelerated to nearly 8 percent and will increase an average of 6.5 percent this year. Rising prices will weaken household purchasing power and keep the growth of consumption weak in the latter part of the year. Despite employment gains, real household incomes are decreasing with little left over for savings,” the Ministry said.
Analysts are expecting the Fed to continue apace with its rate hikes in the face of inflation, which stands now at 8.3 percent annually, with a 0.6 percent uptick in core inflation from July to August.
“After this week’s upside beat on the U.S. [consumer price index], investors will be focused on the Fed’s decision next Thursday, with markets now solidly pricing at least a 75 [basis point] hike,” analysts for Deutsche Bank wrote in a note last week.
“Much attention will be paid to policymakers’ expectations about the path and the magnitude of future hikes. Our U.S. economists expect a 75 [basis point] move next week and have recently published … on why the terminal rate should reach 5 percent,” they wrote.