THE BASIS POINT

Why the Fed Should not Raise Rates.

 

I wrote this in August 2015.

The Federal Reserve has this following mandate: keep unemployment low (under 6%), keep inflation low (under 2%), and keep interest rates moderate.

There are only two reasons why the Fed should consider raising rates: 1) low rates and increased money supply will cause inflation without a hike or 2) the Fed fears that with near zero rates they could not stimulate the economy in the event of a recession because rates were at bottom already. The first point is extremely doubtful. The second point makes some sense.

The reasons why the Fed should not increase are, in my view, much more compelling.

1) GDP growth is slow. We have been averaging 2% annual growth for the past three years. Increasing rates will not help GDP.

2) world economy is hurting: EU, China, India, Venezuela, many emerging nations in South America and Africa. An increase in interest rates in the US would provide more incentive to convert investments to US$ and hurt most everyone else.

The big problem by far is China. The U.S. economy is driven by consumer spending which makes up 70% of GDP. In most EU countries consumer spending makes up about 60% of GDP. In China consumer spending makes up about 36% of GDP. The economy of China is driven by exports and investments. An announcement last weekend showed China’s exports falling 8.9% year over year. In 2012 China’s investments made up 46% of GDP. Exports are about 27% of Chinese GDP.

Chinese equity markets have been hard hit lately. They are up substantially year on year but have been propped up by government buying of equities. In the U.S. the affected parties have likely been hedge funds heavy in Chinese equities. There is, as yet, no indication that this has had any contagious effects on a wider set of financial entities. Events such as this trigger memories of the LTCM crisis of 1998.

China’s problems surfaced this week with its deliberate currency devaluation designed to make its exports cheaper and regain some of the lost 8.9% of exports. China alleged that the devaluation was a one-time thing but that is highly unlikely. China’s devaluation accomplished the same thing as a Fed hike.

The countries which will be hardest hit by China’s devaluation are those with a large percent of their exports going to China. These are Australia, South Korea, Taiwan, New Zealand, Japan, and Malaysia.

Raising US interest rates would make what is happening with currencies worse by strengthening the US$ at the worst possible time. A stronger US$ would hurt US GDP by making exports more expensive and imports less expensive. It will also hurt the economies of the EU nations, weak economies in South America and most of the economies of African emerging nations.

 Many nations depend on exporting commodities for survival and a stronger US$ would lower commodity prices and hurt the cash flows of these nations. This has the potential to create political instability with consequences that we cannot possibly foresee.

My concern is that the Fed could ignore this and instead raise rates to assert that its monetary policy has successfully worked.

 

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