US rate hike highlights the region’s policy limitations

The unintended fiscal consequences of higher US interest rates.

The US central bank raised interest rates on Wednesday. The US economy is recovering: growth is picking up, unemployment is falling, inflation is rising and the long overhang from the 2008 crisis may well be behind us. This forced the central bank to raise rates to prevent the economy from overheating and inflation from rising to uncomfortable levels.

Many central banks in the region followed the US and raised rates. As their currencies are pegged to the US dollar, many countries in the region were forced to follow the US by raising rates. Absent this rate increase, capital would have flown out of these countries into the US to benefit from higher rates, creating pressure on the currencies and the peg.

Higher interest rates would lead to slower growth in the region. Higher interest rates reduce investments by increasing borrowing costs. Higher rates also lower consumption by making saving become more attractive. Both of these factors should lead to lower economic activity.

The fiscal position could exacerbate the slowdown from higher interest rates. Due to lower oil prices, many of the region’s governments are reliant on borrowing to finance their deficits. But if borrowing costs rise, some governments may decide to borrow less and cut their spending instead. Therefore, the fiscal response could propagate the slowdown interest rate increases.

Despite the recent pickup in interest rate, appetite for borrowing has not diminished. For example, Oman borrowed $5 billion from international markets on 8 March, followed by Kuwait borrowing $8 billion on 13 March.

But the situation highlights the region’s policy limitations. While the currency peg to the US dollar makes sense from an economic view, it leaves government spending as the main tool to manage the economy as interest rates are tied to their counterparts in the US. But if government spending becomes responsive to interest rates, then the region has no truly independent policy options to manage the business cycle. This unfortunate situation came about because the decline in oil prices coincided with higher growth and interest rates in the US.