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The Fed Plays Chicken With The Global Economy Watch Free Video

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When the Federal Reserve next meets on September 16-17, they will decide whether to increase the Federal Funds rate for the first time in nearly 10 years. For months now, the Fed has been indicating that it probably would begin hiking interest rates at its September FOMC meeting. However, the recent turmoil in the global equities, commodities and currencies markets, along with the very rapid deterioration in the global economy, suggests that a Fed rate hike at this time would be a disastrous mistake. In this blog we are going to weigh the pros and cons of a September “liftoff” from the Fed’s perspective.

Let’s begin with the reasons the Fed might want to go ahead and begin increasing rates now. First, to some extent, the Fed’s credibility is at stake. They have been leading the world to expect a September hike for some time. Their message has been that the US economy has recovered enough to begin “normalizing” interest rates. Of course, the current situation, with the Federal Funds rate very near 0%, is anything but normal. If they don’t deliver, it will be clear that the US economy has not recovered enough to withstand higher rates and it will be clear that the Fed governors did not know what they were talking about.

Second, one of the reasons the Fed wanted to increase interest rates is because they were afraid that asset prices would keep inflating into an uncontrollable bubble if they didn’t. That was a genuine risk. Now, however, after the near panic in the financial markets during much of August, many stocks are much less overvalued. In fact, the odds of a market crash now appear to be at least as great as those of an out-of-control bubble forming.

Third, the US unemployment rate has come down more quickly than expected. It’s now just 5.3%. This is near the level the Fed considers to be “full employment”. Many Fed members have expressed concern that full employment will soon lead to high rates of inflation if the Fed does not begin increasing interest rates this year.

Now, let’s consider the reasons the Fed might delay the planned liftoff. First and foremost, they are terrified that if they do hike interest rates, the stock markets in the US and around the world will crash and cause the United States and the rest of the world to collapse back into severe recession or worse. That, of course, would be a disaster. The market meltdown in August suggests the Fed should be afraid of a market crash. And, for the Fed, a crash would be a double disaster because it would have to immediately reverse course by cutting interest rates again and, most probably, launching a new round of Quantitative Easing to push asset prices back up. This would be a loss of face on a monumental scale.

The possibility of a market crash is real. The global economy is very weak. Credit growth is not rapid enough in the US to generate strong economic growth there. Consequently, US imports are no longer growing enough to drive the global economy. Weakness in US demand has been enough to prick China’s very large and already vulnerable economic bubble, which has now begun to deflate rapidly. The violent slowdown in Chinese demand has caused commodity prices to crash to levels last seen in the twentieth century, sending the economies and currencies of the commodity producing countries into a downward spiral.

On August 11th, China sent shock waves around the world by devaluing its currency by 3% to make its exports more competitive. Talk of a Fed rate hike had caused the Chinese Yuan to appreciate along with the US Dollar against most other currencies over the last year, since the Yuan is closely tied to the Dollar. China is already the main source of the deflationary pressures in the world. The more it devalues its currency, the greater the deflationary forces will become. Therefore, the Yuan devaluation may have been a warning to the Fed that China would devalue further if the Fed does hike rates.

Inflation in United States is already far below the Fed’s target of 2%. Although the US unemployment rate has come down, US wages remain depressed. Plunging commodity prices may very well push the country into deflation. Corporate profits are already falling.

In my opinion, the arguments against increasing interest rates at this time are much stronger than those supporting a rate hike – overwhelmingly so. Therefore, it is puzzling why, against this very troubled background, the Fed still insists on playing chicken with the global economy.

I have recently made a new Macro Watch video that explains why the global economy remains in serious crisis. If you would like to watch it for free, click on the link below:

Original publish date: September 01, 2015

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