The US Federal Reserve in its meeting held on June 16, 2022 increased the federal-funds target rate by 0.75 per cent to 1.5 per cent. An increase in rates was largely necessitated by a surge in demand of goods and services in the US economy, following monetary expansion during the Covid-19 pandemic that did not only lead to supply side constraints, but also resulted in an increase in prices across the board, with inflation in the US running at a 40-year high. Such a surge in inflation to a four-decade high can largely be attributed to a mix of demand factors due to near zero interest rates for almost a decade, as well as a surge in oil prices, and consequently in the price of gasoline at the pump which led to increased inflation, and erosion of purchasing power in real terms.
Arresting such runaway inflation necessitated an increase in interest rates such that the demand-pull nature of inflation can be tamed, resulting in the largest interest rate increase of 0.75 per cent since 1994, while also signaling that rates would increase further during the current year. This clearly suggests that the US economy is headed for a slowdown till the time inflation is brought under control within the long-term target range.
Such a hawkish approach of the Federal Reserve would be followed by a coordinated monetary response from other major central banks such as the European Central Bank, the Bank of England, and possibly the Bank of Japan. As central banks around the world transition towards a hawkish stance, growth rates across the developed and emerging markets will taper off. A supply side response which enhances supply of oil and reduces prices of energy may shave off some inflation, but any reversal of interest rates would largely be done once inflation is within the long-term target range.
Pakistan being a borrower in the international markets, and from multilaterals in US dollars will see its borrowing costs increase, which will have an impact on its overall interest payments. Similarly, most of our power projects and other CPEC projects have debt denominated in US dollars, which will also see their borrowing cost increase, eventually having an adverse impact on electricity prices. The era of free money is pretty much at its end. Pakistan being a frontier market will see its cost of capital increase, which may further exacerbate our already vulnerable economic position.