Strong or Volcker? The Fed and global financial stability

THE US Federal Reserve’s aggressive monetary tightening is on a scale that the world has not seen since the early 1980s. Over the past year, US securities markets have suffered substantial losses, yet the US economy and financial system remain on reasonably solid ground. The situation abroad is more precarious. Higher US interest rates and a strong dollar are disrupting cross-border capital flows and straining the finances of countries holding large amounts of dollar-denominated debt.

The impact of Fed policy on the global financial system is yet another feature of the Covid-19 pandemic that caught investors off-guard. But much like post-pandemic inflation, it is hardly unprecedented. Ever since World War I ended, US monetary policy has shaped cross-border capital flows, central bank policies, and debt-servicing sustainability throughout the world. This is a power that the United States assumed when it became the world’s largest creditor after World War I and the world’s primary reserve currency issuer after World War II.

Fed policies will undoubtedly rattle the world again over the coming months. In fact, the United Nations Conference on Trade and Development issued an ominous report warning of potentially severe ramifications in some of the most vulnerable nations. Beyond these generalities, however, how Fed policy will play out across the globe is difficult to predict. But one question is worth pondering: Will the Fed adjust its policies in the interest of global financial stability? There are two scenarios from history that may help answer this question.