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

Since the outbreak of the global financial and economic crisis in 2008/09, the key interest rates of all advanced economies have been close to zero. At least in the U.S., the Federal Reserve will raise its interest rates in 2022. This article explains why the U.S. can afford to take this step – and the euro area isn’t there yet.

Inflation rates rise strongly worldwide

With the beginning of the economic crisis in spring 2020, triggered by the corona pandemic, demand for goods and services fell worldwide. This led to price declines – especially for raw materials such as oil and gas.

With the economic recovery in 2021, demand for goods increased again. The overall supply of goods in the economy could not and cannot fully meet this demand. As a result, consumer prices are rising.

The increase in consumer prices is currently highest in the U.S. Therefore, it is to be expected that a monetary policy with higher interest rates will be introduced there first.

The coming interest rate turnaround in the U.S.

Due to rising consumer prices, the U.S. central bank (the Federal Reserve System, or Fed) has already announced that it will raise the key U.S. interest rate in 2022.

However, this is associated with negative effects on output, employment, and growth for the U.S. economy:

• Rising interest rates increase the cost of borrowing. Credit-financed purchases of consumer goods decline. Private consumer demand therefore drops.
• Rising interest rates increase the cost of borrowing for companies. Credit-financed investments become less attractive. Demand for machinery and other physical production equipment thus falls.
• Higher borrowing costs also result for the government. Higher interest rates limit its borrowing options, with the result that government demand for goods declines.
• When aggregate demand for goods decreases, companies reduce their production. This diminishes their demand for labor, i.e., unemployment increases.

In addition, there are negative consequences for public finances in the form of higher government interest expenditures.

Nevertheless, the Fed has opted for this monetary policy course. I see two main reasons for doing so: high economic growth and the unique role of the U.S. dollar as the global reserve currency.

Robust growth cushions a drop in demand

On the one hand, the U.S. economy is developing more dynamically than the European economy. A look at the rates of change in real GDP in both economies shows that in 2018 and 2019, U.S. growth rates were greater than those in the euro area. And the slump in real GDP in 2020 was only half as high in the U.S. as in the euro area. For 2021 and 2022, estimates regarding economic recovery are stronger for the U.S. economy than for the euro area.

If the U.S. economy is growing strongly, the declines in investment and consumer demand resulting from a rise in interest rates are less significant. Therefore, the U.S. economy can better cope with the growth-dampening effects of higher interest rates than the euro area.

This strong economic growth also means that there is a high level of employment in the U.S. This makes it easier to deal with the growth-dampening effects of an interest rate hike. Apart from a short period at the beginning of the Corona pandemic, the American unemployment rate has been noticeably lower than in the euro area both before and after this phase. Therefore, the burden on the labor market associated with a higher interest rate is lower in the U.S. than in the euro area.

However, strong growth can trigger a wage-price spiral

When consumer prices rise sharply, the purchasing power of wage incomes declines. Workers adjust their demands for wage increases to this rate of inflation and demand correspondingly high nominal wage increases.

The resulting increase in the costs of production is passed on by companies to consumers through further price increases. These price increases in turn lead to further nominal wage rises. The result is a wage-price spiral. Inflation becomes entrenched.

Whether workers can actually push their wage demands through depends largely on the level of unemployment: if there are many unemployed – then there are many people looking for a job and accepting wage cuts for it if necessary.

It then becomes difficult for workers to push through their demands. If, on the other hand, labor is scarce, this strengthens the bargaining position of the workers. So, in order to prevent a wage-price spiral at the current high level of employment in the U.S., an interest rate hike by the Fed is necessary. In the euro area, this pressure to act is less.

U.S. dollar as global reserve currency

On the other hand, the U.S. has the advantage of possessing the only global reserve currency at present. This makes it easier for the American government to take out loans. Since investors in the rest of the world use the US dollar as a “safe haven” for their savings, they seek to acquire American assets such as interest-bearing assets. This means a high demand for U.S. debt securities. American economic agents who need credit can obtain it easily.

This has considerable advantages for the American government: Despite the rise in interest rates and the resulting increase in government debt, the state is not threatened with a loss of credit rating. Therefore, no large increases in risk premiums for U.S. government bonds are to be feared. The increase in interest expenditure remains manageable.

Outlook

The combination of higher economic momentum with the availability of the only global reserve currency has two key consequences for the Fed’s monetary policy in the U.S.:

First, inflationary pressures are higher in the U.S. than in the euro area due to stronger economic growth and because of the looming wage-price spiral. So the need for a rate hike is greater in the U.S. than in Europe.

Secondly, the negative consequences of a higher interest rate – i.e. growth-dampening effects and the debt-increasing effect – are smaller in the U.S. than in the euro area.

As a result, the Fed is more likely than the ECB, i.e. the European Central Bank, to raise the key interest rate. We will discuss the additional difficulties facing the ECB in another blog post in coming weeks.

BIO NOTE

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.