The Federal Reserve will announce later today whether it will raise interest rates for the first time since 2006. Whatever the Fed does, we need to look at the big picture. And when we do, we might conclude today’s decision probably doesn’t matter that much. Any rate hike will be small, and there's a chance it may have to be reversed. Here’s why.
First, the US economy is not all it’s cracked-up to be. Sure, the US economy has been doing relatively well. Jobs have been created, unemployment has fallen, and home prices have recovered. But as Jeremy Grantham pointed out in his recent quarterly letter, we have stagnant median wages, a declining labor participation rate, and gloomy death rate statistics for middle-aged whites.
Further, we’re seeing brewing chaos in the junk bond market that might soon infect other markets. In fact, bond fund manager Jeffrey Gundlach highlighted “real carnage” in this market as reason the Fed should exercise caution if and when it chooses to raise rates.
And inflation in America has been contained. We have not (yet?) had the runaway inflation that many believe quantitative easing would produce. Rather, inflation has been stubbornly low. It stands at just .25%. Even if you disregard energy and food prices it works out to 1.3%, meaningfully below the Fed’s 2% target. In fact, the US economy has been missing the Fed’s inflation target for three and a half years. And inflation expectations are now declining.
One driver of this development has been the strong US dollar. As it strengthened, our import bill has shrunk. How’s that? Foreign goods become cheaper in dollar terms. The flip side of that coin is that a strong dollar hurts American multinationals and manufacturers that try to sell good overseas. US exports—from cars to medical equipment to drugs to airplanes—become less competitive.
To be fair, some economists argue that the risks of keeping rates low are greater than the risks of raising rates. After all, low rates hurt those on fixed incomes and other savers while encouraging investors to make increasingly risky bets to generate returns. And as I noted in Boombustology, easy money and cheap credit is a contributing factor to asset bubbles. There are also some respected economists, like Martin Feldstein, that are worried about looming inflation.
Second, the Fed may well end up having to reverse course in the near future if current global economic dynamics persist. Remember how the BRIC countries were supposed to drive the global economy forward for decades to come? Well, the BRICs are crumbling. Brazil is in the midst of a nasty recession, its currency has fallen more than 40% so far this year, and corruption scandals are rocking government and business alike. Russia too is suffering. Low commodity prices, economic sanctions, and an increasingly isolationist regime are hurting growth. India is sputtering along, but the battle between Modi and the bureaucracy continues. And China is coping with the bursting of a credit-fueled investment bubble. Its slowdown is also wreaking havoc throughout the world via plunging commodity prices. Unsurprisingly, the UN recently cut its forecast for global economic growth this year by .4%, to 2.4%.
Further, the world is suffering from having too much supply and not enough demand. That’s why prices have been falling. Look at oil – technology helped supply boom, while anemic global growth and alternative energies limited demand. Higher supply plus lower demand equals lower prices. This has happened to numerous commodities and many goods and services. It all adds up to deflationary pressures that have kept a lid on inflation.
And there are lots of other developments that could really hurt the global economy. Take oil prices, for instance. Countries like Saudi Arabia, Nigeria, and even Canada are facing tighter budgets, shifting politics, and economic uncertainty. Or what about the refugee crisis flowing from Middle East instability? Might it cause European borders to be less porous? Finally, consider demographics. Japan and Germany, for instance, are facing large headwinds as their labor pools begin shrinking in the near future. Sensing similar dynamics, the Chinese government just relaxed it’s one child policy. Where else might demographic policies affect economics in the near term?
Ultimately, however, a rising middle class in the emerging world will lead to an unprecedented consumption boom that will turn this global economic frown upside down. But until then, we must pay attention to these cross currents if we wish to navigate safely through a treacherous global economy.
Let’s be honest, today’s Fed actions are unlikely to actually matter. A one-time .25% increase will have a minuscule effect. It’s not really about the rate hike per se. It’s about the trend the Fed expects to take in 2016 and beyond. If the Fed does take an assertive stance, the cost of credit might increase substantially. If the Fed increased rates towards 2%, for instance, we’d see sizable hikes in credit card, student loan, and mortgage monthly payments. And by the way, let’s not forget that higher credit costs dampen economic activity. Too sharp a hike too fast might generate a self-inflicted downturn.
The reality of an interconnected global economy is that what happens in China doesn’t stay in China. And what happens in the United States won’t stay in the United States. So however the Fed proceeds, it’s clear its actions are constrained by forces outside of its control.