The global economy will be tested by an unusual divergence among the world’s leading central banks in the year ahead: The Federal Reserve is poised to continue raising interest rates while its counterparts in Europe and Japan engage in full-throttle monetary easing.
The U.S. dollar has already strengthened nearly 25% in the past 18 months as investors began to anticipate the prospect of higher U.S. rates. That high exchange rate has already been blamed for crimping exports and putting deflationary pressure on the U.S., and could be a key source of risk for the economy in 2016.
“It will be an interesting experiment,” said Paul Ashworth, chief U.S. economist for the consultancy Capital Economics. “It depends how far everyone goes in opposite directions. Certainly we’re going to get another drag on U.S. exports.”
The European Central Bank, the Bank of England and the Fed have typically moved in unison since the euro’s launch in 1999. The booming global economy of the late 1990s led all three to raise rates into the year 2000. From 2001 to 2003 all three cut rates in the aftermath of the collapsing tech bubble. Even Japan raised its target rate briefly in 2000, only to lower it back to zero in 2001.
This pattern repeated in the years around the global financial crisis, with the central banks raising rates into 2006 or 2007 but then sharply cutting them as the severity of the recession became clear.
Moving in unison helps buffet currencies from swinging around too wildly. If everyone is cutting or raising rates, there’s less pressure to switch from one currency to another. But if the U.S. offers much higher rates than Europe, it could prompt even more global investors to buy dollars.
The divergence could become quite significant. The Fed has stopped printing money and initiated a quarter-point rate increase in December. Fed officials have estimated they will raise rates one percentage point in 2016, 2017 and 2018. Meanwhile, the ECB in December cut its deposit rate to minus-0.3% from minus-0.2%, meaning institutions have to pay even more to park money there, and has pledged to continue its bond-buying program, known as quantitative easing, through March 2017.
If increases put too much pressure on the U.S. economy, the Fed may have to stop raising rates or even reverse course. That was the outcome for the ECB in 2011, when it briefly attempted to raise rates while the Fed was still in the midst of an easing program. The ECB quickly found the eurozone economy wasn’t strong enough to sustain higher rates. The European stock market tumbled and the continent’s debt crisis intensified. By the end of the year, the ECB cut rates.
A similar outcome in the U.S. is not unthinkable, and officials may have to change policy to address it, said Megan Greene, the chief economist for John Hancock Asset Management. “If their mandate is financial stability, they have a responsibility to respond to huge asset movements,” she said.
The divergence could prompt changes in Europe and Japan, too. The flip side of a stronger dollar would be a weaker euro and yen. That could help lift their economies, boosting their manufacturing sectors and providing a more effective stimulus in those economies. “The Fed will do some of the BOJ and ECB’s work for them,” Ms. Greene said.
U.S. exporters and manufacturers could be especially at risk as the divergence plays out. From 2010 to 2014, the U.S. added over 800,000 jobs in durable-goods manufacturing, boosted in part by rising exports. Since March 2015, those jobs have been in decline again.
“Manufacturing has been relatively disappointing,” said Chad Moutray, chief economist at the National Association of Manufacturers. “For the Fed to continue raising rates, they’re going to be looking for progress in the broader economy and that obviously includes manufacturing.”
A strong dollar would also tend to keep commodity prices lower. That would benefit many consumers and businesses that are helped by lower import prices. But it would continue the woes of America’s oil-production industry, another sector of the economy that had been a source of job growth through 2014 but is now shrinking.
***Written by Josh Zumbrun of the Wall Street Journal.