Global Navigator from KPMG Economics

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This edition of Global Navigator focuses on the outsized role the Federal Reserve plays in determining the policies of other central banks, how that relationship has shifted, and what its decision to scale back rate cuts means for other central banks:

1. The Fed has scaled back its timing and pace of rate cuts. Financial markets got ahead of the Fed on rate cuts at the turn of the year. A shift in Fed communications, notably since the March Federal Open Market Committee (FOMC) meeting, has forced market participants shift their views. Markets now align with our own forecast for two cuts in 2024, starting in September.
2. Developed economies and large emerging markets (EMs) are better positioned to weather delays. Thus far, a delay in rate cuts by the Fed has had a muted impact on the decisions of other central banks. The question is whether it can stay that way. Our developed counterparts have not shifted their timeline on rate cuts in response to delays by the Fed. The same is true of large EMs, which have learned from past mistakes and are better sheltered against the downstream effects of Fed policy decisions than in the past. 
3. There are no islands in the global economy. The slowdown in rate cuts will still impact everything from currency shifts to the performance of our largest trading partners, even if the effects are more muted than in the past. Smaller EMs, which have benefitted from a restacking of supply chains, remain the most vulnerable to the spillover effects on their currencies, economies and government budgets.

The reserve currency status of the US dollar has given the Fed a unique role when it comes to setting monetary policy the world over. When it moves, so do the currencies of every other economy that is linked to the value of the dollar. Historically, those shifts have had an impact on the timing and pace of rate shifts elsewhere in the world.

Sharp and divergent movements in policy can be particularly costly for EMs, where large swings in the foreign exchange value of their currencies can spur inflation via more expensive imports. That forces central banks to counter those moves with aggressive rate hikes even if they were hoping to cut, which increases the interest expense on their debt. Capital flight ensues, as investors lose confidence in the country’s ability to make good on their debt obligations, which can trigger a full-blown financial crisis.

This inflation cycle has overturned what was previously taken as gospel. Emerging market economies have better weathered this rate hike cycle by the Fed for several reasons. An International Monetary Fund (IMF) study cites improved central bank independence and credibility; robust foreign currency reserves; lessened dependence on foreign capital; and a more extreme initial hiking response than the Fed that created a buffer from capital outflows as reasons for this reduced sensitivity to Fed decisions.

A slower glide path 

Participants at the March FOMC meeting moved much closer to two instead of three rate cuts for 2024 than they were in December; 9 of 19 participants expected two cuts or less at the end of that meeting. Stronger growth and hotter inflation measures following that meeting pushed toward delaying further. Nearly all the speeches and interviews following the March meeting were more hawkish – relaying a reluctance to cut – than the tenor of Chairman Jay Powell’s comments at the press conference immediately after the meeting.

Our forecast is now for only two rate cuts in 2024, starting in September, down from three cuts last month. The risk that we get even less than that is rising. We are not expecting to return to the ultralow or near zero rates of the 2010s and the start of the pandemic any time soon. The terminal or non-inflationary short-term fed funds rate has also likely moved up closer to 3%.

The effects of the slower glide path on Fed rate cuts have only begun to be felt in global financial markets. Most central banks still plan to cut sooner and more aggressively than the Fed in 2024. That is an outcome that would have been unimaginable just a few months ago and underscores some decoupling in the decisions of central banks. Rates moved up together around the world, even if rate hikes themselves were not synchronized; the path down on rates could break that pattern. 

With stagnant economies, inflation decelerating and inflation expectations well anchored, the Bank of Canada (BoC), the European Central Bank (ECB) and the Bank of England (BoE) are in good positions to cut rates before the Fed. The anchoring of inflation expectations is critical; they help determine how restrictive a central bank deems their policy stance and, in so doing, open the door to cuts.

Most private sector forecasters are more bearish on the outlook for Canada than the BoC. The squeeze of higher rates is felt much more acutely by homeowners in Canada; mortgages rates are not fixed for as long as they are in the US; a large swath of mortgages are scheduled to reprice at much higher rates in 2024.

The discrepancy between private sector forecasts and that by the BoC is a boost to consumer spending. The BoC sees more upside due to the surge in immigration the country has experienced in recent years. Still, inflation has moderated, while unemployment has moved higher. Those shifts suggest the first rate cut will occur in June with a total of three cuts expected for the year. The BoC is more worried about persistent inflation than private sector forecasters due to their strong assumptions on consumer spending.

The eurozone escaped a full-blown, painful recession in 2023, but performance diverged by country. Germany and the Netherlands experienced “technical recessions” – two negative quarters of growth – without a commensurate rise in unemployment. Inflation has cooled but wage growth remains above the ECB’s comfort zone. A lack of productivity growth makes higher wages harder to absorb and ups the risk that persistent strength in wages could stall the progress on inflation.

Still, the ECB is expected to cut sooner than the Fed. Markets expect between 3-4 cuts this year. The base case from our UK colleagues, who cover the eurozone, is for a total of 100 basis points in cuts, starting in June.

Market participants are already acting on this expectation. Germany, which dominates the Eurozone, saw investment flows into the country increase in recent months. Bond investors snapped up German Bunds on the hopes that their values would rise as the ECB began to cut. Bond values move in the opposite direction as rates, rising when rates fall and vice versa. 

The UK is hoping to rebound from a stagnant 2023, with gains driven by a boost in service sector activity. Inflation is expected to decelerate from 7.3% in 2023 to 2.0% by year end. The BOE is forecast to start cuts this summer for a total of 100 basis points in the latter half of 2024.

Japan is the outlier. The Bank of Japan (BoJ) raised its policy rate out of negative territory for the first time in 16 years in response to a more prolonged inflation. Many expected that to tank financial markets and boost the value of the yen against the value of the dollar. Instead, financial markets rallied and the yen depreciated. The BoJ’s communications on the move were more dovish than financial market participants expected. That spooked investors that the BoJ would not be able to keep inflation expectations well-anchored; core inflation has been above target for nearly two years.  

Research by the Fed shows that economic crises in EMs due to tight US monetary policy are not inevitable. Context matters. Everything from why the Fed started raising rates to the economic conditions in economies most at risk of spillover effects can limit damages. Impacts of the speed at which the Fed cuts are not uniform; Latin America and Africa are more sensitive to the pace at which the Fed rolls back restrictive policy; impacts are negligible for the Euro Area and Asia.

So far large EMs have weathered rate hikes by the Fed relatively unscathed. That was not the expectation before the Fed started to raise rates. Many, including leaders at the IMF, warned that a rapid tightening of credit conditions by the Fed posed an existential threat to EMs.

How did the large EMs avoid repeating past mistakes and resulting financial crises?

• Their central banks are more independent and less susceptible to political pressure than they were in the past.
•  They have adopted more inflation-targeting regimes to shore up their credibility with global investors.
• Their fiscal situations are generally more sound, which has reduced the pressure on central banks to print money to close budget gaps. That has helped break the vicious inflation cycles of the past.
• Many countries have amassed large foreign exchange reserves, which they can deploy instead of rate hikes to dampen the effect that shrinking interest rate differentials with the US can have on their currencies. Brazil recently used reserves to do just that. That has diminished the risk of debt and financial crises. 

A red flag would be a sustained drawdown of foreign exchange reserves by EMs. It could signal worse economic and financial troubles, such as not being able to meet its debt obligations. From 2021-2023, Pakistan drained its foreign exchange reserves; inflation spiked, requiring the country to seek help from the IMF.

Chart 2 shows that real interest rates (monetary policy rates less inflation expectations) in various EMs are projected to stay elevated compared to the US rate, which should help prevent capital flight. As a result, large EMs are better suited to withstand external shocks.

The Fed’s rate path is not set in stone. Hotter-than-expected inflation or jobs reports could mean that cuts will be further delayed. Some market participants are now expecting one or no cuts in rates this year. The scenario is not out of the question and coming closer to fruition in our own outlook. Atlanta Fed President Raphael Bostic, who is a voting member of the committee, recently expressed his skepticism that the Fed would be able to cut at all in 2024.

“Higher for longer” means that the cost of doing business is higher not just in the US but also globally. The bank lending rate in Mexico is 11.6% compared to 8.5% in the US; both are more than 3.5 percentage points greater than pre-pandemic rates. Companies which have delayed the repricing of debt issued when rates were much lower are at particular risk for a squeeze in margins. Many commercial office buildings are in that mix.

Interest rate volatility has fallen from 2022 and 2023 levels but is still above the long-run historical average. While hedging can alleviate some of the uncertainty around the path of rate cuts, it will come at a cost. Rollover risk in both EMs and developed economies can substantially impact debt servicing costs.

Recent strong US data drove Treasury yields up, sending equity markets around the world down. The US dollar has strengthened relative to other currencies showing that even though the Fed cannot force other central banks’ hands, its control over Treasury yields is still influential.

The swings in currencies could also intensify relative to the dollar, even across developed economies. That would put downward pressure on the cost of imports to the US and could intensify foreign competition for domestic producers.

Risks: The most vulnerable countries to the Fed’s tight monetary policy are smaller and less developed EMs. The World Bank has shown that 28 small EMs are currently suffering from debt crises and the ability to access global credit markets. While the base case is that negative spillover effects are minimal to large EMs, changes to the Fed’s path, an unexpected shock or domestic conditions in the EMs can increase risks.

This is at the same time that negative supply shocks, from geopolitical tensions to the surge in disruptions due to climate-related disasters, make the global economy more susceptible to bouts of inflation. Central banks then must seek to counteract those shifts. That is the exact opposite of the supply shocks that accompanied globalization and the deceleration in inflation we saw in the global economy of the previous four decades, which put a floor under global interest rates and the volatility that accompanied them. 

The Fed is expected to hold rates higher for longer. Central banks are now less tethered to the Fed’s path, especially in Canada, the EU and the UK. They are expected to cut before the Fed. Larger EMs are better positioned to weather a slower glide to the Fed’s rate cut path than smaller EMs, but they may need to slow the pace of anticipated rate cuts this year. Overall, the Fed still matters. In a recent move higher by US Treasury yields, global equity and bond markets and currencies reacted. Higher for longer will impact exchange rates, import prices, trade and the potential for many economies to grow. The base case is that the global economy avoids a large crisis or meltdown this year, but risks of a misstep are rising.