Why an increase in US interest rates matters to the whole world

Updated on
Federal Reserve Chair Janet Yellen speaks during a media briefing at the Federal Reserve on June 17, 2015.
Federal Reserve Chair Janet Yellen speaks during a media briefing at the Federal Reserve on June 17, 2015. 

It finally happened. The US Federal Reserve announced Wednesday that it is raising record-low interest rates for the first time in almost a decade. 

It’s hard to overstate the importance of this decision, which will bring near-zero interest rates up to about .25 percent. The impact will be felt around the world. 

Everything from the interest rate on your credit card to the dollar-denominated loan taken out by a company in Malaysia will be affected.

The World Bank and International Monetary Fund had implored the Fed to keep the federal funds rate at between 0 percent and 0.25 percent, where it has been hovering since late 2008, until the global economic recovery is on a stronger footing.

“The world economy is looking so troubled that if the US goes in for a very quick move in the middle of this I feel it is going to affect countries quite badly," World Bank Chief Economist Kaushik Basu told the Financial Times in September, when it seemed the Fed was on the verge of announcing a rate hike.

The IMF noted that global economic growth had slowed in the first six months of this year, compared with the second half of 2014, “reflecting a further slowdown in emerging markets and a weaker recovery in advanced economies.”  

Now is not the time to tighten monetary policy, it warned.

But how can the interest rate of a single country affect the rest of the world?

The US dollar is the currency most widely used in international trade, and changes to US monetary policy affect its value, which means pretty much everyone is impacted.

The impact is especially strong in emerging markets.

Just the anticipation of a US interest rate hike has triggered massive outflows of funds from emerging markets, such as China and India, as investors switch their money into dollar-denominated assets to profit from relatively higher interest rates — whenever that eventually happens — and seek shelter in a dollar currency considered by many to be a safe haven.  

In August alone, investors sold $8.7 billion worth of stocks in emerging economies, according to the Institute of International Finance.

More from GlobalPost: Brazil is becoming a bargain destination

That has created turmoil in the financial markets of those countries and driven up the value of the dollar against their currencies. (Except in the case of China, where the renminbi is loosely pegged to the value of the greenback. The renminbi has risen in value, making China's exports more expensive and prompting authorities to devalue the currency last month to prop up the economy, which did nothing to instill confidence in the Asian powerhouse.)

While a weaker currency makes the exports of emerging economies cheaper overseas, it also means that the dollar-denominated loans that non-US borrowers (banks excluded) took out when the world was flooded with cheap money are now more expensive to pay back. The total value of all that borrowing was estimated to be $9.6 trillion at the end of March, according to the Bank for International Settlements. That's got people worried about defaults

That's the squeeze for emerging markets. 

And really, what's the benefit of having cheaper exports if one of your biggest customers, China, isn't buying that much anymore? 

All this turmoil caused by US interest rate speculation is happening at a time when the Chinese economy, the second largest in the world and a key driver of global growth, appears to be slowing at a pace faster than many people had previously thought.

That has had a huge impact on the prices of international commodities, such as iron ore, coal, copper and oil.

As China’s economy weakens, so too does its appetite for those raw materials, which is bad news for the emerging countries that are heavily reliant on commodity exports to drive their economies.

What borrowers and investors really want right now is some certainty, which is why some emerging markets have actually been calling on the Federal Reserve to raise rates already. Rip off the bandage. Get it over and done with so everyone can move on. 

"We think US monetary policymakers have got confused about what to do. The uncertainty has created the turmoil," Mirza Adityaswara, deputy governor at Indonesia's central bank, told the Financial Times.

"The situation will recover the sooner the Fed makes a decision and then gives expectation to the market that they [will] increase [rates] one or two times and then stop.”

But that might be wishful thinking. Wednesday's announcement will more likely spark speculation of when the Fed will move next.

And so the cycle continues.