the Fed’s rate rise dilemma

It’s looking more and more to me as if the Fed is being paralyzed into inaction by worries about two possible negative effects of beginning to raise rates now.  The dilemma is that the current zero interest rate policy is playing a large role in making each situation worse.


The IMF is arguing that economies in the emerging world are too fragile at present to withstand even a small rate rise in the US.  The agency points out that many emerging economies are very dependent on dollar-denominated natural resources, and therefore are being hurt badly by the current slump in demand for minerals.  In addition, many have borrowed heavily in US dollars to finance industrial (read: natural resources) capacity expansion.  Even a small rise in US interest rates, the IMF says, could spark a sharp upward spike in the value of the dollar against other currencies.  This would further dampen demand for natural resources.  At the same time it would make the local currency cost of dollar-denominated loans skyrocket, possibly into impossible-to-repay territory.  In other words, the Fed could trigger an emerging market crisis similar to the one in smaller Asian countries in the late 1990s.

Of course, what made natural resources firms so foolish as to create wild overcapacity?   …one big reason has been the availability of cheap (by historical standards) dollar-denominated loans.   What has prompted (and continues to prompt) US investors (among many others) to take the risk of lending crazy-large amounts of money for projects in places they know nothing about and for projects they didn’t understand   …years and years of low interest rates on Treasury securities and other safe alternative caused by the Fed’s intensive-care low rates.


The Fed has carefully studied the failure of Japan in the early 1990s to reignite economic growth after its economic meltdown in late 1989.  The key factor there, in the Fed’s view (mine, too, for what that’s worth) was that the country tried to remove policy stimulus too soon.  The Fed knows that it has already used up all its economy-healing power, so the country would be reliant on Washington for fiscal stimulus to rescue us in the event it makes a similar mistake.  But we all know that Congress has a poor track record for corrective action in crisis and is particularly dysfunctional now.  So the price to the economy of acting too soon could be very high.

How is it, though, that Congress has been able to ignore its economic responsibilities for so long?  …it’s at least partly due to the fact that the Fed continues to cover for lack of legislative action by running a super-easy monetary policy.  The Fed is an enabler.


my thoughts

Neither threat to policy normalization–the potential effect on emerging markets and the lack of an economic backup–is going to go away.  Arguably, the situation will deteriorate the longer the Fed waits.  I think the Fed should start the normalization process now.

Olivier Blanchard on economics

Olivier Blanchard, the chief economist of the IMF during the financial crisis, is now leaving that organization for the Peterson Institute.  Monday’s Wall Street Journal contains excerpts from his reflections on the state of the world–and of macroeconomics as a discipline–that are contained in full in the most recent IMF Survey (the WSJ has all the high spots, I think).

What caught my eye was Mr. Blanchard’s admission that macroeconomics was caught flat-footed by the recent global financial crisis.

How so?

My paraphrase of his explanation, with which he might not want to agree, is that:

–the discipline believed that a small, highly abstract set of theoretical relationships among the main moving parts of national economies and their external links, a set fleshed out in the wake of the 1930s depression, was enough to ensure they had complete understanding of the 21st century world.  That has turned out to be completely wrong.  In particular, the idea that economic policy makers need not bother to learn the details of the functioning of the banking system or about the inner workings of the small number of global mega-banks proved to be a costly error.

Yes, it took a humongous crisis to shake macroeconomists’ core beliefs and to begin to lessen their contempt for microeconomics.

What strikes me the most is that there is, as far as I can detect, no similar crisis of conscience on the part of academic finance.  The theoretical underpinnings of this discipline lie in quasi-religious beliefs of the 18th century and are far more suspect.  Its theoretical framework has no failed to predict or explain any of the financial crises that have occurred since its creation in the 1960s-70s.  In fact, the speculative frenzy and subsequent financial meltdown of the early 1970s, one of the greatest counterexamples to academic financial theory postulates, was occurring outside the windows of the ivory tower as academics were nailing down its main planks.


It takes a lot of intellectual fortitude for a researcher spending a lifetime dealing with abstractions to admit that knowledge of the “plumbing” behind the walls of his theoretical house actually matters.  A renaissance of macro thinking appears to be in the offing, as a result, of this realization in economics.  One can only hope that the same light one day shines on academic finance.  I’m not willing to bet, however, that this will happen any time soon.


the IMF request to the US–don’t start raising rates until 2016

the report

In its annual review of the US economy, the IMF has included a request that the Fed postpone raising rates until the first half of 2016  (I’ve searched without success for the 10-page analysis on the IMF website, so I’m relying on the FT and Bloomberg for my information.)

To start with the obvious, this can’t be the first discussion of the idea of pushing back rate hikes between the IMF–dominated by EU interests–and the Fed.  The release isn’t the act of some nerdy economist (is there any other kind?) tacking the request on to a report that the top figures in the IMF didn’t review.

No, this is the IMF going on record as saying  it thinks the Fed beginning to normalize rates this year is a bad idea   …and that its request for delay has been rebuffed by the Fed.

the rationale

Its rationale seems to be that higher short-term interest rates might cause a sharp contraction in credit availability in the US and a consequent inadvertent loss in domestic economic growth momentum.  Given that the EU is counting on reasonable demand in the US for its exports, the follow-of effect of the US stalling might be disappearance of green shoots of recovery in the EU as well.

Higher rates might also cause the US dollar to rise.  While a stronger currency would slow the US economy further, it would also increase the attractiveness of foreign goods and services (including vacations) vs. domestic.  The latter factor would be an overall plus for the EU.  Companies would be the main beneficiaries, however.  Ordinary consumers would be hurt through a rise in the price of dollar-denominated goods like food and fuel.

the response

The consensus view in the US, I think, is that:

–official statistics understate the strength of the US economy,

–seven years of intensive-care-low interest rates in the US is long enough,

–a rise of .25% or .50% in rates would have no negative effect

–it might also be a positive, in the sense that the Fed would be signalling that the economy can at least partially fend for itself.

In short, the view is that prolonging anticipatory anxiety is far worse than raising rates a tiny bit and seeing what happens.

The EU economy, on the other hand, is maybe two years behind the US in absorbing the negative effects of the near collapse of the financial sector.  Instead of flooding the area with money–the US approach–it has relied on collective austerity to heal itself.   Sort of like leeching vs. antibiotics.

So the EU has less ability to deal with the negative effects of a US slowdown than the US itself has.  Dollar strength would be another blow to an already beaten-down EU consumer, fueling further politically disruptive far right sentiment, which to me already looks pretty ugly.

In the Greenspan era, the US would probably have accommodated the EU.  Post-Greenspan Fed chairs have made it clear, in contrast, that US interests come first.  The IMF comments reinforce that this is still the case.

The IMF’s latest economic forecast

the July World Economic Outlook

On July 7th, the IMF released its latest adjustment to its World Economic Outlook initially published in April.  There are three main changes:

1.  The agency is raising its forecast for world growth in 2010, by .4% to 4.3%.  Two reasons for this:

Recovery in the advanced economies from the financial shock of 2008 is proceeding faster than the IMF anticipated, even just three months ago.  As a result, it is boosting its forecast for these countries by .3%.  The US is a relative laggard, but it still doing .2% better than the IMF thought.

Partly because of increased demand from the advanced economies, partly from the internal dynamism of China, India and Brazil,  developing economies are doing .5% better than expected.

2.  The aggregate 2011 growth forecast remains unchanged, but its composition shifts. The IMF now thinks the US expand by 2.9% in real terms next year, or .3% faster than it figured in April.  This gain is offset by a .2% reduction in the growth forecast for the EU, from a 1.6% gain to 1.4%.

Faster recovery this year in the advanced economies implies that inventory replenishment there will be completed earlier than expected.  The IMF figures that .1% of growth that it had penciled in for next year will occur in 2010 instead.

3. The IMF comments on possible financial fallout from the EU next year. Its observations are helpful in the sense that I think they offer a worst-case scenario.  The IMF base case is a “muddle through” scenario, with some loss of output in Europe both this year and next because of financial turbulence.  The alternative–the assumption by the IMF that EU governments allow the situation to spiral downward to the point that an EU financial crisis does the same amount of damage to the world as the US financial crisis of 2008–then, the IMF thinks, world growth next year will be reduced by 1.5% from the current forecast of 4.3%.

The IMF gives no reasons for why a second financial crisis should be as large as the first.  On the other hand, I don’t think the IMF analysis is intended to be a realistic assessment.  Instead, I think it’s supposed to be a first approximation of the order of magnitude of a second major financial shock.  My guess is that because the public already half-fears more financial troubles, the shock would be less than the first.  Government action would probably be more focussed, as well.  In any event, though, I think the interesting aspect of the IMF economic simulation is that, unlike the case in 2009–when world output contracted by .6%–2011 would still be a period of global economic expansion.

Let’s make another back-of-the-envelope calculation on the assumption that half the pain would be felt in the EU and the rest would be distributed equally around the rest of the world.  That would imply that European output would fall by about 2% in 2011, producing the second recessionary year there out of three.  The US would grow, but only by about 2.2%.  The developing world would slow down to a “mere” 5%+ growth rate.

Again, the interesting thing for an investor is that ex the EU most individual countries would still be expanding through the European pain.

my conclusion

I think this is another piece of evidence that world economies are in better shape than the consensus thinks.  And, as the IMF itself has commented elsewhere, the numbers point investors toward stock markets in developing countries.