As monetary tightening mounts, a growing number of economists are warning of a historic downturn in the global economy, with the cumulative impact potentially being worse than expected.

The big fiscal tightening began in spring 2021, when a handful of central banks in Latin America and Central Europe began raising interest rates to calm their faltering currencies and curb inflation. By the end of the year, other rich countries such as Norway and South Korea had joined the project.

Almost all major economies are now firmly on the brakes. Over the past five decades, the political focus has never been so much on raising interest rates.

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In view of the increasing tightening of monetary policy, more and more economists are now warning of the consequences of this economic policy, which is being implemented rapidly and synchronously but is largely uncoordinated. Former IMF chief economist Maurice Obstfeld recently argued that unless central banks consider the global ramifications of their policies, the global economy risks experiencing a “historic” downturn. Even if individual interest rate increases are justifiable, taken as a whole they could have unexpectedly large consequences.

Rising inflation is the result of too much money chasing a limited supply of goods and services. By raising interest rates, central banks are attempting to curb growth by curbing spending. But in the globalized economy, this spending crosses borders.

If a central bank intervenes to curb demand, this has a direct impact on the consumption of foreign goods – and thus helps other central banks to deal with their own inflation problem. If such “spillover effects” are not taken into account, the global economy will be slowed down more than the individual central banks had originally intended.

Financial flows run parallel to this process. Interest rate hikes in a country can attract foreign investors, causing a currency appreciation. The resulting fall in import costs, in turn, cools domestic inflation. For other countries, on the other hand, higher import costs arise, which results in an intensified inflation problem.

If monetary policy is tightened in an uncoordinated manner, a kind of currency war can ensue, in which each country works to shift the burden of inflation onto other countries – with the result that the tightening is too severe.

However, the most serious global coordination problem is probably less that each central bank acts for itself. Instead, with the American Federal Reserve, one main player dominates events, which the others inevitably have to follow. The oversized influence of the dollar in the world financial system secures you a powerful tool for controlling global financial cycles.

As a recent study by Princeton University’s Maurice Obstfeld and Haonan Zhou shows, monetary tightening in America has been closely associated with an appreciation of the dollar and a downturn in many global economic and financial policies.

The Fed’s efforts to curb American inflation to a 2 percent level also limits the leeway that is required to take other economies into account. For example, it should welcome interest rate hikes abroad as a helpful contribution in the fight against American inflation, even if the other countries fall like dominoes into recession.

In fact, as more idle capacity is created in other economies as downward pressure on international prices mounts, America’s unemployment rate needs to grow less to meet the Fed’s targets.

Since then Treasury Secretary John Connally declared to the representatives of the major economies in 1971: “The dollar is our currency, but your problem”, financial integration in the world has become much stronger. However, as interest rates climb in an uncoordinated manner around the world, the prospect of surviving the crisis unscathed continues to decline for any economy.

The article first appeared in The Economist under the title “Global rate rises are happening on an unprecedented scale” and was translated by Cornelia Zink.

The article “Global rate hikes reach historic proportions – with serious consequences” comes from The Economist.