The answer is that the Federal Reserve should proceed very cautiously.
On Wednesday August 1 the Federal Reserve announced that it would hold short-term interest rates steady for the time being. This announcement followed a two-day policy meeting. Nevertheless, many expect the Federal Reserve to increase rates further beginning in September.
“Traders expect the Federal Reserve to raise borrowing costs twice more this year. They see a 92% probability that it will raise the fed funds rate to a range of 2% to 2.25% in September.”
Trade Disputes Won’t Deter the Fed
It has been suggested by some that #trade disputes between the United States and both #China and the #European Union might cause the Federal Reserve to hesitate. However, this appears not to be so.
“Escalating U.S. trade fights with other countries aren’t throwing the Federal Reserve off its course of gradually raising interest rates as the economy strengthens. At least not yet.” Fed policy makers have already bumped up interest rates seven times since late 2015. This after rates were held near zero for several years following the 2008 financial crisis. And they intend to raise rates two more times this year.
Part of the reason for raising rates is that #inflation has begun to reassert itself.
In the 12 months through July, the CPI increased 2.9 percent, matching the increase in June.
“As the July CPI figures make clear, underlying price pressures are still mounting.” This according to Michael Pearce, senior U.S. economist at Capital Economics in New York.
Inflation pressures are seen continuing to build amid low unemployment and increasing difficulty reported by employers in filling positions. Rising raw material costs are also expected to push up inflation as manufacturers pay more, in part because of tariffs imposed by the Trump administration on lumber, aluminum and steel imports.
“The Fed anticipates that inflation will overshoot its 2% target this year; in March, officials saw that happening only in 2020.”
In addition, the Fed also believes that the U.S. economy is sufficiently strong to absorb further rate hikes. “Information received since the Federal Open Market Committee met in May indicates that the labor market has continued to strengthen and that economic activity has been rising at a solid rate. Job gains have been strong, on average, in recent months, and the unemployment rate has declined. Recent data suggest that growth of household spending has picked up, while business fixed investment has continued to grow strongly.
Some observers have warned that inflation is more virulent than presently acknowledged.
Paul Tudor Jones said inflation is about to appear “with a vengeance” and may force the new Federal Reserve chair to accelerate interest-rate hikes.
The hedge fund manager said policy has focused on a “low inflation problem” and years of near-zero rates amid economic expansion will have “painful” consequences. Policy makers should have been more aggressive in tightening policy and “rejecting the fiscal impropriety associated with this most recent tax cut,” he said.
“We are replaying an age-old storyline of financial bubbles that has been played many times before,” Jones, founder of Tudor Investment Corp., wrote in a Feb. 2 letter to clients. “This market’s current temperament feels so much like either Japan in 1989 or the U.S. in 1999. And the events that have transpired so far this January make me feel more convinced than ever of this repeating history.”
The President’s Remarks
In a stinging and historically rare criticism, President Donald Trump expressed frustration with the Federal Reserve and said the central bank could disrupt the economic recovery.
“I’m not thrilled,” he told CNBC’s Joe Kernen in an interview on “Squawk Box.” “Because we go up and every time you go up they want to raise rates again. I don’t really — I am not happy about it. But at the same time I’m letting them do what they feel is best.”
#Fed Chairman #Jerome Powell and other Fed officials did not comment on the president’s remarks. The White House, in a statement after the interview excerpt aired on CNBC, emphasized that Trump did not mean to influence the Fed’s decision-making process.
“I don’t like all of this work that we’re putting into the economy and then I see rates going up,” he said.
We Did It
President Trump’s remarks are not without justification. We should keep in mind that the Federal Reserve has a checkered history. In the past the Fed has many times moved from one extreme to the other. Why would this cycle be any different?
“In 2002, Ben Bernanke, then a member of the Federal Reserve Board of Governors, acknowledged publicly what economists have long believed. The Federal Reserve’s mistakes contributed to the “worst economic disaster in American history” (Bernanke 2002).
“Regarding the Great Depression, … we did it. We’re very sorry. … We won’t do it again.” #Ben Bernanke, November 8, 2002, in a speech given at “A Conference to Honor Milton Friedman … On the Occasion of His 90th Birthday.”
More recently, the Federal Reserve was instrumental in the crash of #2008. Without doubt many banks had engaged in reckless investment schemes. And unethical lending practices were widespread. Nevertheless, the role of the Federal Reserve in causing the credit contraction that precipitated the ultimate collapse in the financial markets should not be overlooked. The Fed caused the financial crisis of 2008.
“Many Americans probably believe that continuous boom and bust cycles are natural occurrences. The truth is we would not experience such dramatic economic swings were it not for monetary policies that distort real prices and encourage improper investment decisions. Boom and bust cycles are inevitable when government interventions confuse market participants.”
Another Financial Crisis
Many effects of central bank interest rate policies are not felt immediately. There is a risk that if the Fed overreacts to legitimate inflation concerns, they could prompt another financial crisis.
#Mark Mobius is a well-respected investor and observer of financial markets.
“There’s no question we’ll see a financial crisis sooner or later because we must remember we’re coming off from a period of cheap money,” the veteran investor in developing nations said in an interview in Singapore. “There’s going to be a real squeeze for many of these companies that depended upon cheap money to keep on going.”
Early Signs of Contraction
Furthermore, some believe that we are already seeing the first signs of weakness in the financial markets.
Emerging-market debt crises are as predictable as spring rain. They happen every 15–20 years, with a few variations and exceptions.
We are now at the beginning of the third major EM debt crisis in the past 35 years.
The hard-currency import coverage for Turkey, Ukraine, Mexico, Argentina and South Africa, among others, is less than one year. This means that in the event of a developed-economy recession or another liquidity crisis where demand for EM exports dried up, the ability of those EMs to keep importing needed inputs would be used up quickly.
Venezuela has defaulted on some of its external debt, and litigation with creditors and seizure of certain assets is underway. Argentina’s reserves have been severely depleted defending its currency, and it has turned to the IMF for emergency funding.
Ukraine, South Africa and Chile are also highly vulnerable to a run on their reserves and a default on their external dollar-denominated debt. Russia is in a relatively strong position because it has relatively little external debt. China has huge external debts but also has huge reserves, over $3 trillion, to deal with those debts.
The problem is not individual sovereign defaults; those are bound to occur. The problem is contagion.
History shows that once a single nation defaults, creditors lose confidence in other emerging markets. Those creditors begin to cash out investments in EMs across the board and a panic begins.
Other Central Banks
The Federal Reserve is not the only central bank that is contemplating higher interest rates.
The #European Central Bank and the #Bank of Japan are still adding to their crisis-era portfolio of securities. Meanwhile, the Federal Reserve, the central bank making the most progress among its peers toward normalizing monetary policy, remains a few hikes away from what’s widely viewed as the neutral interest rate, the threshold above which interest rates can start to crimp economic activity.
The implication of change in central bank policies would be felt in countries outside of the United States, such as Italy and the euro area.
“Though investors see Italy’s political turmoil as a problem contained within the eurozone, the size and extent of the tremors felt across the world suggest it could have troubling implications for the next market selloff when interest rates are higher and central banks have trimmed their balance sheets.”
The Fed’s unwind of its portfolio will hit full stride in September at a monthly pace of $50 billion. Meanwhile, the ECB might look to end its QE program at the same month. This even though some economists expect it to be extended through year-end. And within the senior ranks of the Bank of Japan, policy makers have showed growing concerns over the cost of the BOJ’s protracted use of monetary stimulus.
The convergence of these policies will create the possibility of a perfect storm of credit contraction worldwide.
See also: The World Economy Is At An Epochal Pivot by David Stockman
The Federal Reserve is caught in a serious dilemma. Inflation has reemerged. Therefore, higher interest rates are justified. However, at the same time there are indications that world economies and the financial markets are vulnerable to any shocks. Before raising interest rates further, the Federal Reserve should determine that the eight interest rate hikes that have already been undertaken are insufficient to conquer inflation.