On a Knife Edge: US Interest Rates and the Saving of the Global Economy

I like Greg Ip – a journalist who writes for the Wall Street Journal. I read his column whenever I have the newspaper in hand and his views and understanding of the economy seems to align quite well with mine, most of the time. But this morning I read his piece in the US print edition of the Wall Street Journal, called As Dollar Falls, Global Economy Perks Up (Thanks, Fed).

The article states factually, and shows graphically, how a rising dollar (a phenomena since early 2014) has, for the most part, been a hindrance to the world economy. As the Fed signaled hints of its first rate rise, it’s “lift-off” resulted in a great sucking sound from emerging markets as capital changed direction from high risk markets to the save haven of the US. If interest rates were to rise, better be there on the ground to attract the (slightly) juicer returns. And when we say capital, we are talking of billions of dollars a day in deregulated capital flows. This harmed local currencies, reduced confidence, and generally has been a pain for those emerging markets.  

Once the US interest rate “lift-off” actually started, and the Fed announced an expectation that rates would rise steadily through the year (2016), the strength of the dollar increased and the capital flows toward the US notched up in 2015. Trouble was brewing global as the US economy seemed to be doing quite well when the rest of the world was looking a bit pesky. This, to me, looked like Yellen’s Roosevelt Moment, in reference to the time in 1933 when Roosevelt basically stuck two fingers up at the global economy, torpedoed the World Economic Conference, and took the dollar out of what had been until then, an agreed exchange rate structure.  Any attempt at cooperation to save the global economy was gone.  The US walked off the stage.

What is most interesting since that first rate rise is that Yellen passed the Roosevelt test. The “lift-off” has been much less of a “take-off” and more of a “hold”. Rates have not raised any more, and so the dollar’s rise in value has halted, indeed, it has started to fall. As such capital is again flowing back to towards emerging markets and so stability in the exchange rate and capital flow patterns has begun to emerge. But here is the conundrum that is building: The US economy is certainly not creasing, it is showing fleeting signs of improvement. Should inflation show any hint of an increase, as commodity price falls drop out of the inflation calculation, all talk will again turn to the continued “take-off” as in “vertical movement. That will then reverse capital flows once again, and very sharply. Once inflation kicks in, the Fed will have a devil of a time coping with its pressures due to the unreal level of quantitative easing it has dropped onto the economy. So while Yellen may have passed her initial and most important Roosevelt Moment, she has quite a few similar moments ahead. And we are not playing here with just the US economy – we are playing with the whole shootin’ match!

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