The data on the Federal Reserve website tells that the US economy in 2017 had a better performance than 2016’s, registering a real growth rate of 2.3 per cent compared with 1.5 per cent and exceeding expectations. Moreover, the inflation rate moved to a more comfortable level, while unemployment declines reduced the tension inside the economy.

A Survey of Professional Forecasters predicts the US economy will continue the performance because of several reasons, of which the continuous increase in government expenditures, the noticeable improvements in personal consumption expenditures, and the tax reform package announced in December are notable.

These indicators — and others — have encouraged the Fed to continue rising the federal fund rate (FFR), which is the interest rate at which banks borrow and lend reserves to each other. In December 2015, the Fed started to raise the FFR and continued eight times between January 2016 to March 2018. In the same vein, the interest rate on the excess reserves witnessed a remarkable increase between November 2015 and March 2018.

During the past two years, there was continuous discussion about the optimal long-run size of the Fed’s balance sheet. Technically, there were two strategies. The first calls to keep the balance sheet large as it was after the crisis.

The second one requires it to shrink it to the pre-crisis level. Before the crisis, the Fed managed the FFR by changing the supply of reserves in the financial system. After the expansion of the Fed’s balance sheet, it influenced short-term rates primarily by varying the interest rate it pays banks on their excess reserves.

The debate swung in favour of a return over time to the pre-crisis regime. Further, the vision of the current Fed Chairman Jerome Powell is consistent with that of his predecessor, Janet Yellen. Expectations are that Powell will carry out more frequent and bigger interest rate increases in 2019 and 2020 as the US economy’s performance improves.

Consequently, the next important question is what effect the FFR increase will have on the economies of the Middle East? The data from the International Monetary Fund shows the forecasted growth for these countries are either modest or negative.

This indicates these countries have already a weakness in their aggregate expenditure. An increase in their nominal interest rate will make this problem worse and opens more questions about growth prospects in 2018 and 2019.

To close the loop of this simple analysis, we should look at a third item of the problem. This part is the time and the magnitude of the rise in interest rate imposed by the Fed, which had eight hikes within two years.

I think those frequent changes will add more uncertainty to the investment decisions in the Middle Eastern economies. Higher interest rate may hinder the development of the financial markets and encourage investors to save more in interest rate bearing financial intermediaries. In such circumstances, central banks have limited scope for an independent monetary policy. Accordingly, their contributions will be the form of administration work, regulation, and communication.

Within this scenario, fiscal policy is expected to be more effective than monetary policy under the fixed exchange rate. But this choice has some limitations because of the size of government budget deficits and the high debt ratio in some of the Middle Eastern countries.

— The writer is Associate Professor of Economics, United Arab Emirates University.