Wrongfooted by Fed, World’s Few Hawks Now Stuck With Lower Rates

(Bloomberg) -- The central banks of small open economies from Sweden to Israel that barely tinkered with interest rates as the Federal Reserve tightened monetary policy now find themselves even more out of step with the U.S.

Read more: Powell Suggests Fed Embarking on 1990s-Style Mini Easing Cycle

Pressure is growing on them to abandon plans to raise domestic borrowing costs and swim with the dovish tide, threatening to leave little policy room in case of a future downturn. Israel already took a step on Wednesday by backing off an imminent hike.

The alternative is to accept a wider rate differential with major developed economies that could touch off more gains in their currencies and hurt exports.

“It is a challenge for the central banks of these economies, there's no doubt,” said Kevin Daly, an economist in London at Goldman Sachs Group Inc. “For them to focus exclusively on domestic considerations would result in the inappropriate setting of monetary policy at too tight a level.”

U.S. central bankers lowered rates for the first time in more than a decade after a meeting on Tuesday and Wednesday in Washington. The quarter-percentage point reduction will likely boost appetite for riskier assets following a series of Fed increases to lift its target range from a record low. The European Central Bank is also poised to add more stimulus as soon as September.

“We're in slightly unusual times where usually, or historically, a global easing like this is a boon to economies,” said David Page, head of macro research for AXA Investment Managers. Now, however, “it's not seen as so much of a boon; it's seen as something that increases disinflation risks.”

Read more: Central Banks Are Poised to Act as Economic Warnings Flash

In Israel, the dovish turn has boosted the shekel and choked off inflation, forcing the central bank to back down from its plan to raise rates again after a surprise hike in November. Bank of America Corp. said this month that in case the global downturn worsens, Israel could even be forced to reverse its first increase in borrowing costs since 2011.

“In real terms, it's very difficult for a small open economy to control its interest rate,” said Giancarlo Corsetti, professor of macroeconomics at the University of Cambridge. “The real interest rate is going to be determined internationally.”

Read more: Israel Backs Off Rate Hike as Governor Now Sees Long Pause Ahead

Hours before the Fed's decision on Wednesday, Bank of Israel Governor Amir Yaron said the country's key rate won't rise from 0.25% for a “long time,” changing tack weeks after saying there could be a hike soon. The verbal intervention ended three days of gains by the shekel after it strengthened beyond 3.5 per dollar for the first time since April 2018.

‘Source of Worry'

“The small and open economies are impacted by developments in the large blocs,” Yaron said after the July 8 rate decision. “In recent months, developments in the global economy have been the main source of worry for us.”

A similar situation is playing out across Europe.

In Hungary, real rates are among the lowest globally though the central bank modestly tightened twice this year. Some analysts now say the country will next cut rather than raise its rates.

Nearby, the Czech Republic's central bank took a step back in late June from a campaign to raise rates, as global risks overshadowed high domestic inflation. And in Sweden, although the Riksbank is for now sticking with its own plan to hike, it said “the risks surrounding developments abroad can have a bearing on the prospects for Sweden.”

In fact, Norway appears alone among small open economies that are marching on with planned rate hikes unimpeded. The country's dependence on oil has helped it stand out.

“They are caught between a rock and a hard place,” said Nicolas Veron, senior fellow at the Peterson Institute for International Economics. “They have issues of currency appreciation and just the fact of not being coordinated in terms of cycle, which is not particularly easy to manage.”

To contact the reporter on this story: Ivan Levingston in Tel Aviv at ilevingston@bloomberg.net

To contact the editors responsible for this story: Lin Noueihed at lnoueihed@bloomberg.net, Paul Abelsky

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