Despite rate liftoff, Fed still thinking internationally

Prior to the summer market turmoil surrounding China’s stock market intervention and currency devaluation, most economists had expected the Federal Reserve’s first rate increase since 2006 to come at the September meeting of the Federal Open Market Committee.  The rhetoric coming from Fed officials implying multiple rate hikes by the end of the year supported such a hypothesis.

However, because of the tumult caused by the uncertainty surrounding the knock-on effects of a slowing China, the winds shifted and the Fed held at near-zero rates in September.  Notably, the statement released by the Fed at the conclusion of its meeting noted, for the first time ever, “international developments” as a contributor to the Fed’s decision.  This was unexpected and widened the Fed’s scope as it is has traditionally only considered domestic factors.  International considerations remained in the October and December statements (no meeting in November) and will set a precedent for all rate-setting decisions going forward–a precedent that I would argue is sensible and strengthens the Federal Reserve.

However, despite tepid global growth and troubled emerging markets with strained exchange rate pegs to the dollar, dollar-denominated liabilities, and export sectors priced in dollars, the Federal Reserve this time met market participants’ expectations and raised the federal funds rate by 25 basis points.  While part of the reasoning behind this decision was certainly to maintain the Fed’s credibility (as mentioned above, Fed officials had originally hinted at a September liftoff), the Fed’s decision was not without the international factors carried by the September and October decisions to hold on raising rates.

Following the September delays, officials from emerging markets called for the Fed to just get it over with to remove the uncertainty surrounding its actions.  Indeed, global markets actually rallied upon the news of a borrowing rate increase finally occurring in December.

The second way in which the Federal Reserve lent an ear to international concerns is less obvious.

As I’ve noted in previous posts, the decision to raise rates was by no means a cut and dry decision.  Wage growth and inflation are still below the Fed’s medium-term targets while the specter of secular stagnation gains clout and fiscal policy globally is relatively weak and ineffective at mobilizing the world’s “savings gluts”.  Given decline in the “neutral” real rate (the rate at which the economy remains at full employment and inflation remains in check), it would have been reasonable for the Federal Reserve to keep the federal funds rate on hold until it saw more impressive inflation, perhaps even enough to average 2% over a longer time period instead of simply targeting inflation of 2% in the medium-term.  Indeed, given that the Fed had spent seven years at the zero lower bound prior to raising rates this month, the ability of the Federal Reserve to respond to raising rates too early is much less than its ability to respond if inflation were to suddenly pick up.

However, while the Federal Reserve may be able to more easily respond to the risks of waiting too long to raise rates, the implications for emerging markets would be much harsher.  If inflation were to pick up, the Fed would have to respond my raising rates more quickly.  The “taper tantrum” of 2013 has shown how much global markets hang on the Fed’s every word and move.  A faster path of raising rates–while it would be technically possible, and while it would allow the Fed to wait until it was certain it was time to raise rates–would roil emerging markets.  Emerging market currencies and corporate and sovereign liabilities would all take major hits as rapid currency depreciation and capital outflows became self-reinforcing.

The Fed’s decision to raise rates this month could potentially bring the domestic consequences of a preemptive rate hike–a U.S. slowdown leaving the Federal Reserve with much fewer policy options, as it would quickly return to the zero lower bound.  However, by raising now, and thus more gradually, the Fed will avoid the possibility spurring a self-reinforcing emerging markets crisis that would reverberate around the world, including to the U.S.


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