Inflation was low. So why did Jordan and Saudi Arabia raise interest rates?

Within hours of the Federal Reserve raising interest rates on September 16, Saudi Arabia did the same. Jordan followed five days later. Kuwait stayed where it was.

The easy explanation would be inflation. Perhaps Saudi Arabia and Jordan were responding to the same price pressures that had pushed the Fed to act, while Kuwait saw less reason to move… But the numbers tell a different story.

US consumer prices were 3.4% higher in August than a year earlier. Saudi inflation was only 1.8%. In Jordan, it was 2.66% in August and had averaged 2.2% over the first eight months of the year.

So why would Jordan and Saudi Arabia make money more expensive when their inflation rates were lower than America’s? And why was Kuwait able to wait?

The answer lies less in what was happening to prices and more in what these countries had promised about their currencies.

The decision began in Washington

The Fed raised its benchmark rate by a quarter of a percentage point, taking it to a range of 3.75%–4%. For the United States, the reasoning was fairly direct. Inflation remained above the Fed’s 2% target.  Its preferred PCE price index had risen by 3.7% over the year to July, while economic activity was still expanding.

In other words, the Fed believed the economy was strong enough to absorb another increase while it tried to bring inflation down. The move may not be the last. Sixteen of the Fed’s eighteen policymakers projected at least one more increase before the end of the year. Those projections can change, of course, but they show that the inflation fight is not considered finished.

That explains Washington. It does not, by itself, explain Riyadh or Amman. Their inflation rates were lower and their economies faced different pressures. The connection appears once we look at the exchange rate.

A peg is more than a fixed number

Jordan has tied the dinar to the dollar since 1995, at an average rate of JOD 0.709 for one dollar. Saudi Arabia has kept the riyal at SAR 3.75 to the dollar since 1986.

That stability has real value. An importer knows roughly what a future dollar payment will cost. A business can sign a contract without fearing that a sudden currency fall will wipe out its margin. Families paying expenses in dollars face less uncertainty.

But a peg is not maintained by an announcement alone. People must continue to trust it, and holding the local currency must remain reasonably attractive.

Suppose safe dollar assets begin paying noticeably more while returns on dinar or riyal assets remain unchanged. If the exchange rate is expected to stay fixed, moving into dollars begins to look like the better deal. One depositor will not trouble a central bank. A wider movement in the same direction can increase demand for dollars, put pressure on foreign exchange reserves and make the peg more costly to maintain.

This does not mean a pegged central bank must copy every Fed decision. It can use reserves, liquidity measures and other tools, and some difference between local and US interest rates can persist. Its freedom is simply narrower. The larger the gap becomes, and the longer it lasts, the harder it is to ignore.

Jordan’s central bank was explicit about this. It said the increase was intended to preserve monetary stability, strengthen the attractiveness of the dinar and keep local rates aligned with regional and international markets.

Saudi Arabia used broader language, saying its increase was consistent with its mandate to preserve monetary stability. The Saudi Central Bank raised its repo rate by 25 basis points to 4.5%, and its reverse-repo rate to 4%.

The two statements were not identical, but the monetary setting was similar. The Fed was responding to American inflation. Jordan and Saudi Arabia also had to consider what higher dollar returns meant for confidence in their own currencies.

Why Kuwait could wait

Kuwait made a different choice. Its central bank kept the discount rate at 3.5%.

The Kuwaiti dinar is not linked to the dollar alone. Since 2007, it has been tied to an undisclosed basket of currencies reflecting Kuwait’s main trading and financial relationships. The dollar still matters, but it is not the only reference.

That arrangement gives Kuwait somewhat more room to consider domestic conditions before following the Fed. Its September statement pointed to those conditions: resident deposits were 9.8% higher than a year earlier in July, while credit to residents had increased by 4.8%.

The currency basket was not necessarily the only reason Kuwait held its rate. Its central bank was also looking at liquidity, lending and the wider economy. Nor is Kuwait independent of US monetary policy. The comparison simply shows that different exchange-rate systems leave central banks with different amounts of space.

Saudi Arabia moved immediately. Jordan followed a few days later. Kuwait looked at the same American decision and concluded that it could wait.

The difficult choice behind a stable currency

Economists call this the “impossible trinity.” The name sounds more complicated than the idea.

A country may want a stable exchange rate. It may want money to move relatively freely across its borders. And it may want to set interest rates entirely around its own inflation, jobs and growth. Fully maintaining all three at the same time is difficult. The more firmly a currency is fixed, and the more easily money can move, the less freedom the central bank has to ignore interest-rate changes in the country providing the anchor.

Jordan shows the tension clearly. Inflation was relatively contained, while unemployment among the total population stood at 16.1% in the second quarter. If the central bank had been looking only at domestic demand, making credit more expensive would not have been the obvious response. But it was also protecting monetary stability and confidence in the dinar.

For households, one important detail should not be lost. The Association of Banks in Jordan said banks would not pass this particular increase on to existing personal loans, leaving current monthly instalments unchanged. That assurance applies to this decision; variable-rate loans may still be adjusted over time according to the terms of each contract. Depositors may also receive higher returns.

The effect of one quarter-point increase may be small. It becomes more important when moves accumulate or when a business regularly needs to renew its financing.

None of this means that linking a currency to the dollar is necessarily the wrong choice. A peg brings predictability, and governments may decide that this stability is worth protecting. A floating currency gives a central bank more freedom over interest rates, but allows more of the adjustment to appear in the exchange rate. There is no arrangement without a trade-off.

The Fed did not instruct Jordan or Saudi Arabia to raise rates. It did not have to. By increasing the return available on dollars, it changed the calculation facing every central bank whose currency is closely tied to the dollar.

That is what sits behind these apparently puzzling decisions. Inflation in Jordan and Saudi Arabia was low. But their currencies were closely tied to the dollar, which meant that an interest-rate decision made for the American economy could not remain entirely American.