The following chart shows the short-term interest rates of the U.S., the Eurozone, Sweden, and Switzerland. While the level of interest rates is not the same in these economies, the direction of change is. Furthermore, the U.S. is the leading country. When the FED is easing monetary conditions like in 2001, other advanced economies tend to follow, sometimes with a lag of up to one year. The same pattern can be observed with regards to the tightening cycle in 2006, for example, or the subsequent easing after the outbreak of the financial crisis in 2008.
So now for the first time in a almost two decades we might get a decoupling of monetary policy between the U.S. and Europe. The FED is engaging in a tightening cycle whereas interest rates will remain negative in Europe for the foreseeable future. Financial markets expect U.S. interest rates, on the other hand, to be close to 2% at the end of the year. So here are some troubles I see on the horizon. It is very likely that higher U.S. interest rates will put upward pressure on the dollar. This is a problem for U.S. manufacturing and might lead to further job losses in that sector, which would be the exact opposite outcome that Trump has promised to his voters.
The bigger worry is related to risks in emerging markets because there is a lot of dollar denominated debt. With liabilities in dollars and assets in local currency, an appreciation of the dollar directly worsens the balance sheet if banks, companies and individuals who took on debt in U.S. dollars. This could, in the worst case scenario, trigger a financial crisis in one or several emerging markets, very similar to the Asian crisis in 1997/1998 when currency depreciation led to a deterioration of the domestic balance sheet.
The decoupling of monetary policy between the U.S. on the one hand, and the Eurozone and Japan on the other hand, might be the main monetary event in the years to come. Short-term interest rates might approach 2% in the U.S. by the end of this year whereas they will likely remain negative in the Eurozone and Japan. The underlying reason is, of course, that the U.S. is now operating at full capacity whereas there is still a weakness of aggregate demand in the Eurozone. Merkel and Schäuble who consistently have advocated for higher interest rates in the Eurozone got it completely wrong. No surprise there. The FED can go through with rate hikes right now because FED policy was more expansionary after the crisis. ECB policy, on the other hand, was extremely contractionary at first, which led to the Eurozone crisis. Anybody who wants higher interest rates in the future, should advocate more accommodative monetary policy right now. This is the only way.