The Fed’s worries cannot be solved by interest rates.

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Sara Salim's picture

Fed Chairwoman Yellen highlighted her confidence in the US economy, particularly improved labor market statistics during her December 2nd speech at The Economic Club of Washington. She signaled inclination toward a rate rise in the upcoming December 2015 FOMC meeting, but my prime argument is that the Fed’s main concerns (that lie beyond the borders of the US) that prevented a rate rise for the past three months can no longer be addressed through the interest rate tool. Hence the Fed might as well raise interest rates now.

The difference in the FOMC’s statement on September 17 versus October 28’s is the omission of sentence “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term”. Despite this omission, the committee still noted on October 28 that they will be “monitoring global economic and financial developments”. The Fed is now however at a point where these “developments” that prevented a rise in September, October and November will not be contained by the Fed’s next move. These “developments” refer to external economic weakness particularly in emerging markets that is strengthening the USD with the impact of driving down demand for US exports, slowing GDP growth and lowering inflation expectations. 

Back in September, The Fed was worried that if it raised interest rates, the USD will appreciate, decreasing import prices and lowering domestic inflation expectations. Commodity price shocks at the time meant that commodity exporters (mainly emerging markets) saw their currencies weaken further against the USD. These countries accumulated foreign currency debt, primarily denominated in USD from the boom years which became unsustainable not only because of their weaker currencies, but also due to lower revenues from lower commodity prices. At the time, China was also pushing for CNY inclusion in the SDR basket of currencies which started the process of liberalizing the currency. In the process, the PBoC shocked markets with a sudden devaluation of the CNY (the first step towards a more market-determined currency regime) in August, which caused a rush of capital outflows from China, forcing interventions in the form of asset sales of US financial assets, including US Treasury bills with the effect of strengthening the USD.

Now as we approach December, the Fed cannot prevent further appreciation of the USD because finally, the IMF confirmed on November 30 that the CNY will be included in the SDR basket of currencies.  It is thus no longer possible for China to consistently utilize large amounts of its foreign reserves to maintain the exchange rate of the CNY vs USD, like it has historically. Therefore, in light of China’s slowdown in growth and its current cyclical position (requiring loose policy) and the relatively strong performance of the US economy (requiring tightening), the Fed’s and the PBoC’s monetary policy will sharply move in opposite directions. The USD will continue to appreciate vs the CNY, whether the Fed raises interest rates or not.

The Fed’s “global economic and financial developments” excuse is tossed out of the window. But if that does not bring us to a definitive decision to raise interest rates, what will? History! Alan Greenspan slashed interest rates in light of the dotcom crash of 2000 to avoid a short to medium-term recession. However, he planted the seeds of the subprime mortgage bubble that eventually burst 7 years later and ushered in the financial crisis of 2008. His successor Ben Bernanke, 5 years in the run up to this crisis only raised interest rates very slowly with the objective of promoting economic growth. On hindsight, this must have further inflated the mortgage bubble. When this bubble burst, it set a precedent of close to zero interest rates across the developed economies right to this very day and exposed them to series of volatile boom-bust cycles across financial assets. I trust that Janet Yellen feels it is worthwhile to sacrifice her 2-3 year growth objective by increasing interest rates now, for the sake of longer term stability. A really close eye is being kept on the Fed’s every move so this unpopular decision will be popular soon enough. The Fed might as well raise interest rates now.