Fed to Raise Interest Rates

Ambrose Evans-Pritchard writes at the Telegraph that the Fed is poised to hike rates to tighten the money supply. This is an attempt to stave off an inflationary spiral expected when (or if) unemployment falls much below 6%. It will, he predicts, raise the value of the dollar versus other currencies.

Down further in the article, Ambrose discusses the possible impact on foreign economies:

Yet if America is strong enough to withstand rate rises, it is far from clear what this will do to the rest of the world. A vast wash of dollars flooded the global financial system when the Fed cut rates near zero and then bought $3.5 trillion of bonds. This may now go into reverse. 

... Much of the dollar business is conducted through European and UK banks, leaving them acutely vulnerable to a dollar squeeze. Such episodes can be ferocious. It was a dollar liquidity shock that turned the Lehman affair into a global banking crisis, instantly engulfing Europe in October 2008. 

Emerging markets went into a tailspin last year at the first suggestion of Fed bond tapering. There was a sudden stop in capital flows. The "Fragile Five" (India, Indonesia, South Africa, Brazil and Turkey) were punished for current account deficits. ...  

... A study by the International Monetary Fund concluded that the Fed's QE had pushed $470bn into emerging markets that would not otherwise have gone there. IMF officials say nobody knows how much of this hot money will come out again, or how fast. 

The BIS in turn said in its annual report two weeks ago that private companies had borrowed $2 trillion in foreign currencies since 2008 in emerging economies, lately at a real rate of just 1pc. Loans to Chinese companies have tripled to $900bn - some say $1.2 trillion - mostly through Hong Kong and often disguised by opaque swap contracts in what amounts a dangerous carry trade. Countries do not borrow in dollars any longer (mostly) but their banks and industries certainly do. 

The report said monetary largesse in the West has destabilised emerging economies in all kinds of ways. One of the worst - and least understood - ways is that they were forced to choose between internal credit bubbles or surging currencies. Most opted for bubbles as the lesser evil, holding their domestic interest rates at 300 basis points below the safe "Taylor Rule" level. 

This has driven their total debt levels to a record 175pc of GDP. It may be even worse. China has thrown all caution to the wind, pushing credit from $9 trillion to $25 trillion since Lehman. Its debt levels have reached 220pc by some estimates. Officials at both the IMF and the BIS privately doubt whether China can extricate itself smoothly from this.

Read the whole thing.

However, things may not be as rosy as the Fed thinks. Judy Shelton, writing at the New York Sun, observes that the Fed's monetary policy may not have done anything but drive asset bubbles.

The presumed logic of using easy money to reduce unemployment was tentatively probed by a few brave questioners during the hearings. If firms are borrowing to expand operations — hiring more employees to boost production — why did U.S. productive output, as measured by gross domestic product, fall by 2.9% in this year’s first quarter? Ms. Yellen dismissed the negative number as “transitory” yet maintained that “accommodative monetary policy” was still needed to support economic expansion. 

Turns out, though, many of America’s largest corporations have been using low-cost money not to increase their workforce but to buy back their own stock in equity markets. According to a study released in late June by the chief market strategist at brokerage firm LPL Financial, Jeffrey Kleintop, companies purchasing their own shares are the single biggest category of stock buyers. Not only can companies use buybacks to raise their share price, they can also push up the earnings-per-share number (even if earnings are flat) by reducing the amount of outstanding shares. 

Such window dressing adds no real value to the economy. But it does explain why inflation, as measured by the Consumer Price Index, has been relatively subdued. If the increased liquidity provided by the Fed is not filtering beyond boardroom valuation strategies, there is no kick to consumer demand. 

What’s odd is that some advocates of monetary stimulus hail the lack of inflation as a triumph for the Fed’s policies. But after so much pumping, the lack of a dramatic rise in the CPI is not grounds for crowing: It’s proof that the Fed’s policies are not working. Cheap money is not benefiting workers, not increasing consumer demand – and thus not raising prices for goods and services. Inflation is the dog that’s not barking.

So what does this mean? This article at The Street polled some financial experts who seemed to agree that the primary impact will be to raise interest rates for home loans and consumer loans. Among those with variable interest rate loans, expect to see increased defaults and foreclosures. Of course, the costs of servicing the national debt will increase, which may cause some budget battles. And, if the Fed has guessed wrong about inflation, increasing interest rates may be enough to push us into a recession. I would add that if a zero rate created bubbles in the stock market, increasing the rates may have the effect of driving some of that investment out of the stock market, with a resultant decline in stock prices.

Frankly, I don't believe that the economy will recover until energy prices drop. And I doubt that can happen until after the next Presidential election.