Higher for longer rates weigh on US and world

The US Federal Reserve sets monetary policy by adjusting the interest rate big banks pay each other for overnight loans: the Fed funds rate.Changes in that rate ripple through the economy, affecting employment, output and the price of goods and services.The Fed and its vast global audience thought 2024 would be a rate-cut bonanza. But with inflation proving stickier than almost anyone predicted, those expectations are fading fast.Fed Chair Jerome Powell confirmed as much on June 12, when he and his fellow policymakers signalled there would be just one cut in 2024 and forecast more for 2025, reinforcing policymakers’ calls to keep borrowing costs higher for longer to suppress inflation.Traders now see just one or two rate cuts happening this year. That’s a big letdown from the roughly six they expected at the start of the year and the three that Fed officials pencilled in as recently as March.Some investors and economists say there’s a chance of no cuts at all this year.When inflation peaked above 7% in 2022, it reflected a broad-based increase in the price of goods and services. But now, with a key inflation measure back below 3%, price increases are being driven mainly by a persistent shortage of housing. Commodity prices and car insurance premiums are also contributing to the stickiness, keeping inflation above the Fed’s 2% target.Some also point to Powell himself for prematurely telegraphing interest-rate cuts, which ignited optimism in financial markets and fuelled economic activity.The Fed’s benchmark rate affects borrowing costs across the rate spectrum. Powell’s signalling that the Fed might hold the rate at the current level of 5.25-5.5% for longer means that loans for home and car purchases will continue to be much more expensive than they were before the Fed started raising rates in 2022.In fact, average mortgage rates in the US have stayed above 7% for the past two months. The cost of financing has hindered recent momentum in the housing market as prospective buyers move to the sidelines until financing costs ease.Despite the Fed’s stance to stay on hold, some of its global peers are moving forward with rate cuts anyway.Last week, the Bank of Canada led the Group of Seven in lowering borrowing costs, and the European Central Bank (ECB) followed suit. If those institutions, along with the Bank of England (BoE) and Reserve Bank of Australia move ahead with their own easing cycles, that risks driving down their currencies — raising import prices and undermining progress in getting inflation down.The ECB, for its part, all but ruled out a second interest-rate cut in July, and some also question if such a move would be wise at the following meeting in September.The BoE pivot to rate cuts is likely to take longer, with traders pricing the first reduction in the fall.Higher for longer keeps the dollar strong against other currencies, because the prospect of persistently lofty US rates makes investment in US securities more appealing on a relative-value basis, causing the greenback to appreciate.So with every tick higher in the dollar, things gets tougher for developing economies — especially for those that have dollar-denominated debt that becomes more expensive to pay back as their home currency weakens.The Fed’s move to signal fewer interest-rate cuts this year deepens its divergence from peers who have already begun to ease.For the world economy, divergence from the Fed matters. Higher US interest rates stoke dollar strength and will continue to lure foreign capital away from rival economies, especially emerging ones.The Fed’s policy direction impacts the whole financial world, especially emerging markets and economies where local currencies are pegged to the dollar.