Interest Rate Hike by the Fed – What Does it Mean for Europe?

In mid-February, we showed why the US Federal Reserve would soon raise its key interest rates. Now, the Fed has done so. Raising interest rates is a traditional inflation-fighting tool. But it also has a number of negative side effects – for the US, but also for the rest of the world.

Low-interest rates cause inflation to rise

In essence, inflation means that the prices consumers have to pay for goods are rising. This happens when higher demand for consumer goods meets lower supply. The resulting shortage causes prices to rise.

A central reason for the sharp rise in prices in the US is the combination of low-interest loans and extensive government stimulus packages. Low-interest rates are boosting credit-financed demand for consumer and capital goods. The government stimulus packages are also increasing the demand for goods and services

This demand stimulation was necessary to stabilize the weakening economy during the corona pandemic. But if the demand for goods and services grows too much, companies’ supplies are no longer sufficient to meet this demand. This leads to an overheating of the economy – and thus to high inflation rates.

And: According to the Fed, the invasion of Ukraine is “likely to create additional upward pressure on inflation.”

Fighting inflation by raising interest rates

If the US Federal Reserve wants to fight inflation, it must raise interest rates. This dampens demand for goods and services in the US through various channels:

• Rising interest rates increase the cost of borrowing. Credit-financed purchases of consumer goods decline.
• Rising interest rates increase the incentive to build up savings and to receive interest income in the future. This income would expand future consumption opportunities. In the present, however, higher savings mean reduced consumption and so lower demand for consumer goods.
• Rising interest rates reduce credit-financed investments by companies. As a result, demand for capital goods, i.e., machinery and other physical production equipment, falls.
• The government also faces higher credit costs. This restricts its ability to take on debt, so government demand for goods declines.

A slowdown in demand for commodities and services reduces the gap between high demand and lower supply reducing inflationary pressure.

Interest rate hike in the US dampens the economic recovery in the US…

Therefore, rising interest rates reduce inflationary pressure. But this comes at an economic price: If US companies invest less because of higher interest rates, the companies that produce machinery and other production equipment can sell less. They reduce their production volume and need fewer workers. People affected by unemployment have less disposable income – and therefore cut back on their consumer spending.

Companies in the consumer goods industry also reduce their production because private households are cutting their consumer demand. This, too, causes a decline in employment in the US.

Overall, therefore, higher interest rates in the US have the effect of weakening American economic growth. Because of the size of the US economy, this has implications for global economic growth.

… and in the rest of the world

As economic momentum slows in the US, export prospects in the rest of the world become gloomier. For export-oriented companies in Europe and Asia, it becomes less reasonable to expand their production capacities. As a result, investment activities outside the US decline. The result is a drop in production and employment in companies producing capital goods. And this decline in employment – as already described – also affects the consumer goods industry in Europe and Asia.

If economic momentum slows in Europe and Asia due to weaker economic growth in the US, demand for goods in these two regions of the world will decline. And this, in turn, has spillover effects for the entire global economy:

• If European demand for commodities and services slows, the export opportunities of American and Asian companies decline.
• If Asian demand for goods falls, the sales prospects for European and American exporters become gloomier.

Higher interest rates in the US, therefore, slow down the economic upturn in Europe. In addition, American interest rate policy has an impact on exchange rates.

Interest rate hike in the US = depreciation of the euro

A rise in interest rates in the US makes it more attractive for international capital investors to withdraw their money from regions with lower interest rates and invest it in the US instead. This has consequences for the exchange rate of the dollar and the euro:

• If more people demand more US dollars, the value of the dollar increases. There is an appreciation of the dollar.
• At the same time, demand for euros falls. The result is a devaluation of the euro.

For economic development in Europe, these exchange rate changes have positive and negative effects:

• The euro’s devaluation makes European products cheaper in the US. Exports by European companies increase. This raises production and employment – the GDP of the EU grows.
• European companies that rely on inputs and raw materials from abroad and have to pay for them in dollars have to spend more on these imports. This mainly affects raw materials, e.g., oil. The costs of production for European companies rise. This worsens their sales opportunities – both in Europe and in the rest of the world. Employment and GDP, therefore, decline in the EU.
• European consumers who want US products also have to pay more. Hence the purchasing power of their incomes shrinks. As a result, they can afford fewer European products. When demand for European consumer goods declines, companies adjust. Consequently, employment and GDP in the EU continue to drop.

In terms of GDP development in the EU, the devaluation of the euro resulting from the interest rate hike in the US has both advantages and disadvantages. It is unclear which effect predominates.

Nevertheless, the EU can expect adverse economic developments if another effect of the interest rate rise in the US is taken into account: the fact that this will also force the European Central Bank (ECB) to raise interest rates sooner or later.

Interest rate hike in the US forces the ECB to raise interest rates

The withdrawal of capital from the EU already outlined makes it more difficult for companies and governments in Europe to obtain new loans. However, these are urgently needed. This is particularly true after a deep recession.

Many companies and governments had to borrow during the recession. When they now have to repay some of these debts, this is often done by taking out new loans: A company borrows five million euros to pay off an old loan of the same amount. But if interest rates on the new loan are higher, the company has to generate the interest payments required to pay them.

In the case of individual companies whose economic situation is difficult, the banks may doubt that these companies will be able to make their interest payments in the future. With such a pessimistic view, it is reasonable from the bank’s perspective not to grant any further credit. The same applies to particularly highly indebted states, federal states, or municipalities.

Risk of loan defaults increases

If individual borrowers do not receive fresh loans, they can no longer repay maturing loans. In this case, the company or government entity in question is insolvent.

For the banks that granted these loans, this means a loss of assets – they have to write off the loans. In the worst case, this puts the bank in financial distress. And if a bank is unable to pay, this could be the start of another global financial market crisis – as happened after the Lehman bankruptcy in September 2008 .

What is to be done?

Raising interest rates to combat excessive inflation is a double-edged sword:

• A well-measured increase in interest rates weakens demand for goods and thus dampens inflation.
• An excessively large increase can trigger an economic crisis by slowing economic momentum and causing loan repayments to fail.

To prevent the latter, central banks should announce their planned interest rate hikes for the future well in advance. Then all economic players have the opportunity to prepare for higher interest rates. Highly indebted companies and governments, in particular, can think about measures to secure their solvency.

However, some companies will, in all likelihood, not survive economically if interest rates on loans rise. This applies especially to so-called “zombie companies” – “that is, firms that cannot generate enough profits to cover debt-servicing costs and need to borrow to stay alive.” So far, they have only survived because interest rates are currently extremely low worldwide.

It will be crucial to flank such corporate bankruptcies with economic policy to prevent a domino effect as we experienced after the Lehman bankruptcy. In the past, this was attempted by providing sufficient liquidity to the economic system and thus preventing further corporate bankruptcies. However, this is precisely the monetary base that later results in inflation. In addition to the uncertainties caused by the Ukraine war, this dilemma will accompany us in 2022.

About the author

Thieß Petersen is Senior Advisor at the Bertelsmann Stiftung, specializing in macro-economic studies and economics. His focus lies on the causes and effects of financial and economic crises as well as the chances and risks of globalization. Most recently, he worked on the effects of carbon pricing and the benefits of a potential global climate club.

Read more about this topic:

Inflation, Unemployment and Public Debt – the Dilemma Facing the European Central Bank

The U.S. is on the Verge of an Interest Rate 180 – But the Euro area not Yet