How Will the Fed’s Loosening Cycle Impact the Gulf?

The upcoming easing cycle by the U.S. Federal Reserve is likely to have significant effects on Gulf economies, as the central banks in these nations are expected to adjust their policies in response to the Fed’s actions, given their fixed exchange rates to the dollar and open capital accounts, as noted by Capital Economics.

While decreasing interest rates may alleviate some costs associated with debt servicing, the overall impact on economic growth in the Gulf is anticipated to be minimal.

The analysts at Capital Economics predict that the Fed will reduce the federal funds rate by 25 basis points in September, with additional cuts anticipated, culminating in a total reduction of 200 basis points by the end of 2025. Consequently, Gulf central banks will likely follow suit and lower their rates.

This situation is explained by the “impossible trinity,” which asserts that fixed exchange rate commitments and the free movement of capital necessitate that Gulf interest rates align with those of the U.S. As such, interbank interest rates in the Gulf tend to mirror U.S. rates, though with a premium required by investors willing to hold local currencies instead of dollars.

The impact of this looser monetary policy on the Gulf can be observed in two main areas.

First, lowering interest rates is expected to decrease debt servicing costs for both businesses and households. This could open up opportunities for refinancing existing loans or taking on new ones at lower rates. In Saudi Arabia, where many loans are variable-rate, this adjustment could provide considerable relief, potentially alleviating worries about rising non-performing loans.

Second, lower interest rates could alter incentives related to saving and borrowing. With decreased returns on savings, households might be less motivated to save, leading to increased consumption. Additionally, as borrowing costs decline, demand for credit could rise.

However, Capital Economics expresses some caution regarding the likelihood of substantial credit growth. They point out that, despite potential rate cuts, interest rates may remain relatively high compared to historical standards. Moreover, past data indicates that oil prices are a more significant factor influencing credit growth in the Gulf region. Strong oil prices generally enhance fiscal conditions and bolster non-oil sectors, thus fostering a conducive lending environment. Given that current oil prices hover around $72 per barrel and are not expected to surpass $75 in the near future, the projected boost to credit growth may be limited.

In summary, while the Fed’s easing cycle is poised to lower interest rates in the Gulf, Capital Economics concludes that the broader economic impact will likely be constrained. They project that non-oil GDP growth across the region will decelerate, particularly as fiscal policies become less favorable in the years ahead.