South-Western College Publishing - Economics  
Is the Fed a slowpoke?
Subject Stable Dollar
Topic International Finance
Key Words

Stable Dollar, Federal Funds Rate, and World Economies

News Story

American monetary policy exerts a huge influence on the rest of the world. Central bankers all over the world will be wrestling with the question of how the Fed's move to increase the federal funds rate will affect their own economies. For example, the Fed's move to a higher federal funds target interest rate will narrow the gap in interest rates between the United States and the twelve nations using the euro.

The recent rise in the value of the euro against the dollar has raised alarm that European exports could be priced out of foreign markets. If so, the European economic recovery could stall. The Fed's intervention to raise interest rates in the U.S. should stabilize the recently sinking dollar and keep European exports competitive. Because of this, "Alan Greenspan will get a lot of applause in Frankfurt," said Holger Schmieding, an economist at Bank of America in London. "The U.S. is reducing the risk of what Europe fears most."

The Fed's move will also stabilize the dollar's value around the world, arresting the dollar's sinking value in recent months. A stable dollar also aids central banks in Japan and Southeast Asia. These countries, major exporters to the United States, have suffered economically as the sinking dollar made their products less attractive as exports. Since most Asian economies, especially Japan, are not particularly concerned about inflation as these countries try to climb out of recessions, most economist expect the Japanese central bank to keep short-term rates close to zero and not follow the Fed's lead. One exception is Indonesia, where inflationary trends may call for higher interest rates.

China has experienced torrid economic growth and mounting inflation, a situation that calls for higher interest rates. However, the notion of higher rates has met with great resistance. Since the Yuan's value is tied to the dollar, it might be easier now for Chinese bankers to follow the Fed and raise Chinese interest rates also. "While it may take a while, China must increase rates as the Fed does," said Andy Zie, the China economist at Morgan Stanley in Hong Kong. "China needs to tighten," said Dong Tao, an economist at Credit Suisse in Hong Kong. "Now with the Fed tightening they can move on interest rates as well. "

England may face no need to follow the Fed in raising rates. The Bank of England already implemented increased rates in November and again in February. While most economists consider the Fed the foundation of world finance, not all central banks will follow the U.S. lead in raising rates. It depends on each country's particular economic condition. "The Fed is the cornerstone," said Norbert Walter, chief economist of Deutsche Bank, "but you don't always need to follow the cornerstone." Walter, like many others, considers the Fed's move long overdue and describe the Fed not as a trailblazer but as a slowpoke.

(Updated August, 2004)

Questions
1.

Explain what Schmieding is talking about with the phrase, "…what Europe fears most."

2. Is a sinking dollar appreciating or depreciating? Is a sinking dollar good or bad for the U.S.?
3. What is the normal policy response, in terms of interest rates, for an economy experiencing "torrid economic growth" as in China's case?
Source Mark Landler, "Fed's Expected Increase May Offer Respite for Other Central Banks" New York Times Online, June 30, 2004.

Return to the International Finance Index

©1998-2004  South-Western.  All Rights Reserved   webmaster  |  DISCLAIMER