Even if Federal Reserve Chair Janet Yellen decides not to go with a negative interest rate, she will have to scrap the gradual increments over the next few quarters. Inflation is not high enough to worry about, let alone manage, inflation. Yellen said the Fed is already working to understand whether gradual interest rate increases may or may not help the U.S. economy. (Source: “Semiannual Monetary Policy Report to the Congress,” Board of Governors of the Federal Reserve System, February 10, 2016.)
The latest inflation rate for the United States is 0.7%, as published by the U.S. government on January 20 and based on data ending December 2015. Oil prices have fallen since then and inflation is heading lower rather than higher. Ordinarily, this would prompt the Fed, as it would any other central bank, to push for higher rates. The problem is that the U.S. economic outlook is better compared to the economic outlook for the rest of the world.
The United States continues to lead the global economy. However, the gap between it and the rest of the world is too high. The U.S. accounts for almost a quarter of the world’s gross domestic product (GDP). The gap is so high that it has increased the risk of recession in the United States. This is what worries the markets. Janet Yellen has simply confirmed that this threatens the U.S. economy’s health.
Negative Interest Rates? Yep.
Yellen admitted that the market has taken the Fed by surprise. One of the surprise factors has been the oil price crash. The strong dollar was less of a bombshell. Many analysts had expected it because the U.S. economy is stronger than others. What was shocking is the extent to which the U.S. dollar has managed to rise against its major currency rivals.
In December, the Fed has raised interest rates by a quarter of a percentage point, the first increase in more than nine years. However, the decision came in a context in which other central banks decided to cut interest rates. It was not long before abracadabra! The S&P 500 lost 10% of its value.
Since the Fed raised rates on December 14, the global stock markets have fallen like dominos. Treasury yields have fallen and credit spreads have widened. Moreover, oil and commodity prices have plummeted. This is hurting too many developing economies, which suffer when the U.S. dollar is too expensive. In turn, this has killed any chance that Yellen will increase rates again in 2016. (Source: “Opinion: Five questions Janet Yellen must answer,” MarketWatch, February 10, 2016.)
Judging by the global trend, with Europe and Japan adopting negative rates, the Fed may have to return to a zero-percent rate. It may even get behind the negative rate cart.
By raising rates, the Fed had hoped to stimulate the global—not just the U.S.—economic outlook.
The tool was going to be reducing inflation. Economists assured us that unemployment rates were dropping, adding pressure to inflation. But this a fact in the United States alone. Across the Atlantic and the Pacific oceans, meanwhile, employment numbers did not increase anywhere near those in the U.S.
The Fed must also contend with the effects of a strong dollar. The greenback is trading at record-highs compared to the euro, the Canadian dollar, and the Mexican peso.
A higher dollar, in turn, decreases the real rate of inflation probably below the Fed’s two-percent target. Inflation is much closer to zero than to two percent. So, by raising rates, the Fed actually moved against one of its main goals.
The higher dollar did not hesitate in showing its effects. Global unemployment and instability reared their heads due to a worldwide slowdown caused by the U.S.’s continued role as the global economic engine. Emerging markets have reacted to the increase in interest rates by the Fed with excessive volatility. Last summer, mere rumors of a Fed rate hike fueled speculation and uncertainty in the Asian markets.
A high dollar, given that negative rates weaken currencies, means that many countries have to pay more for commodities sold in U.S. dollars. Moreover, most of the developing world’s debt is expressed in U.S. dollars; therefore, a higher dollar value lifts their total debt values. The rate hike has already introduced turbulence in the markets. And the markets have already gotten a whiff of this from China over the past few weeks. Even so, the latest employment numbers indicated that employment is reaching record-high levels.
The rate hike in 2016 has put too much pressure on China to reform its financial system. China is reluctant to deregulate and to reduce government manipulation. China has already turned the yuan into an international reserve currency through the SDR mechanism.
The U.S. economy, strong as it may be, remains integrated in the global economy. Its actions have inevitable boomerang consequences. In an economically interdependent world, the collapse of emerging economies has negative reverberations on Wall Street.
The strength of the dollar, after all, is no accident. It has resulted from the heavy capital outflow from investors in emerging economies. It softens their financial systems. Governments then have to adopt high interest rates to avoid currency collapse and hyperinflation.
Industrial and agricultural investments then stagnate. The result is a stalemate: economic crisis leads to financial crisis and back again. More alarming is the possibility of a Greek collapse situation spreading.
Low borrowing rates have stimulated the rise of the economic and financial sector. They have also fueled private individuals’ debt (in U.S. dollars). Should emerging economies collapse, it will be next to impossible for many citizens to honor their huge dollar debt burdens. How will these emerging markets repay their debts if their currencies depreciate against the rising dollar—an inevitable effect of raising interest rates?
Therefore, in 2016, the higher U.S. interest rate increases the risk of a financial and economic collapse. This could be more dramatic than the collapse of Lehman Brothers in 2008.
In sum, if the downside risks of the higher U.S. interest rate and strengthening U.S. dollar materialize, demand for U.S. goods will weaken. The Fed then has little choice but to reverse the current rate back to zero or even go negative. It’s either that or it risks an economic crisis.