Under Global Constraints, the Fed Is More than Disarmed

The Federal Reserve is currently constrained by the rest of the world, which is preventing the Fed from raising interest rates. The result: Its monetary policy will no longer be able to make use, in the end, of the classic weapon of lowering rates. It will only survive using unconventional policy. The risks that the Fed takes will influence the equilibrium of the global economy.

American growth has been disappointing and has left the Fed perplexed. However, upon taking a closer look, nothing alarming emerges from the latest growth figures. Companies have cleared out and at the same time have driven growth downwards. But, household consumption has remained strong (up 4.2 percent) and should stimulate activity in the coming months.

However, the gross domestic product has “only” progressed at an annual growth rate of 1.2 percent in the second trimester of 2016, falling well short of that in 2015 and 2014 of 2.6 percent and 4 percent, respectively. In this context, the Fed remains very cautious and has invariably shifted position on necessary monetary tightening. The American economy has lived on a monetary drip since the crisis. And since 2009, its growth has gained positive ground. The Fed announced that starting in 2015 it would progressively increase its interest rate to leave itself some leeway and to allow it to again support economic activity when the growth cycle returns.

American Growth, Made in China

But, things haven’t happened as expected. The Fed has found itself, for a change, constrained by external factors. Thus, the period of American financial supremacy has ended, a fact that was once announced with impunity by the late Secretary of the Treasury John Connally, who said, “The dollar is our currency, but it’s your problem.” The turbulence in financial markets, particularly in China, geopolitical tensions and their consequences on the price of oil, and Brexit are all elements that render the American economy dependent upon the rest of the world.

In fact, financial ties between different regions obligates the Fed to review its internal ambitions in accordance with external constraints. China remains an unavoidable creditor for the United States. It finances a large part of America’s debt, notably by investing in treasury bonds. Which explains why turbulence in the main Chinese stock markets last summer constrained the Fed in its pursuit of an accommodating monetary policy (that is to say, leaving its interest rates very low) in order to avoid stirring up tensions in China and spreading that tension to the rest of emerging Asia.

A rise in interest rates in the United States, in fact, leads to the risk of depreciation of the dollar. The American currency has already been on the high end for 18 months. With the Chinese currency, the yuan, being stuck in part to the American currency, appreciation in the latter constrains authorities in Beijing to support its currency. This is what they have done in part, all while slowly letting the yuan slip to avoid “overly” emptying the funds that comprise reserve currencies accumulated through trade surpluses. Let’s remember that, thus far, these reserves are invested in assets in Western, particularly American, financial centers. Clearly, the risk for the United States arises from this flow of capital, which, at the mercy of turbulence in financial markets, can cause a ripple effect on the American economy.

Slowdown in Sight

It remains to be seen what will happen when the American economy genuinely starts declining. After six years of fragmented growth, the United States should enter a phase of economic slowdown in 2017. With the upcoming presidential election in November, the status quo is at risk of being the Fed’s preferred option. It only has until the end of December to act, but everything will depend upon which candidate is elected. Donald Trump has already announced that if he wins, Janet Yellen, current president of the Fed, will be replaced and that the institution’s independence will be up for further discussion. Hillary Clinton, for her part, speaks of a necessary change in governance in order to lessen the banking lobby’s influence inside the Fed. The goal is for the interest of “America as a whole” to be better represented by postponing the rise in interest rates as much as possible in order not to burden indebted American households.

Financial Instability and Systemic Risk

In the end, chances are that the United States’ interest rates will remain at a very weak level in the long term. Eventually, American growth will struggle and the Fed will no longer make use of its traditional weapon of lowering its interest rates in order to kick-start the economy. The Fed will only be able to act through so-called “unconventional” monetary policy, which is to say by massively investing in cash flows by buying back assets. But, will economic agents consistently have faith in the efficacy of this policy as well as in the sturdiness of a central bank that has systematically resorted to printing money?

While the crisis of 1929 taught us that doing nothing leads to, de facto, bankruptcy after bankruptcy and to economic depression, it must be concluded that the current commitments of the Fed and of the central banks in general are ticking time bombs. These measures were originally taken in order to confront a crisis. They were considered to be exceptional, and taking into account the risks that they generate in terms of financial instability and systemic risk, cannot be trivialized. Thus, the Fed would do well to neutralize these risks by skillfully proceeding toward a rise in interest rates after a year. But, the globalization of capital flows has rendered the Fed dependent upon the international context in the short term. The Fed has tried and is still trying today to avoid economic disruptions at the risk of one day watching as the bill is presented to the global economy as a whole and when it will remember that “there is no free lunch.”

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