Yellen Faces Greenspan Oasis Warning as She Weighs Rate Rise

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How Much Does Janet Yellen Care About the Selloff?

Former Federal Reserve Chairman Alan Greenspan warned in 1998 that the U.S. could not remain an oasis of prosperity in a world beset by financial turbulence. Now Janet Yellen must decide whether that counsel still holds true.

A rout in emerging markets led by China has triggered an equities sell-off in the U.S., with the Dow Jones Industrial Average dropping by more than 1,000 points in early trading before paring the decline to 588 points, or 3.6 percent, as of 4:15 p.m. in New York. The turbulence has investors questioning whether the durable U.S. economy can withstand weakness abroad and wondering what that means for the timing of the Fed’s interest-rate liftoff.

“If market turmoil continues, the Fed will hold off hiking at the next meeting,” said Jonathan Wright, a professor at Johns Hopkins University in Baltimore and a former economist at the central bank’s Division of Monetary Affairs. “These market movements are getting sizable, and raise downside tail risks to growth and inflation.”

Investors have sharply marked down the probability of a September increase in the Fed’s target for the federal funds rate. They now see only a 22 percent chance that the Fed will raise its zero to 0.25 percent target at the central bank’s gathering on Sept. 16-17, down from 48 percent at the start of last week.

“We move our call for the first rate hike from September 2015 to March 2016,” Michael Gapen, chief U.S. economist at Barclays Capital Inc. in New York, and his colleague Rob Martin, wrote in a note to clients.

2015 Liftoff

Atlanta Fed President Dennis Lockhart, speaking Monday in Berkeley, California, said he still expects the first rate increase later this year, though a stronger dollar, weaker yuan and falling oil prices complicate the U.S. outlook. He declined to spell out if he favored moving in September or delaying. On Aug. 10 Lockhart said he viewed liftoff in September as a “live possibility.”

Fed Chair Yellen told Congress on July 15 that the Fed is likely to raise rates later this year, assuming its forecasts for stronger growth and lower unemployment are realized.

Former Treasury Secretary Lawrence Summers evoked the memory of the 1997-98 Asian financial crisis in a Twitter message Monday. Summers, a professor at Harvard University, said the world “could be in the early stage of a very serious situation” as he made the argument against a Fed move. As a deputy Treasury secretary in 1997-98, Summers dealt with fallout from the turmoil in Asian markets.

“The balance of risks is towards more financial instability, slower growth, disinflation and deflation,” Summers elaborated in an interview on Monday. “That’s not a time to be raising rates.’

Asian Crisis

‘‘There are some definite parallels to 1998 when you had the Asian financial crisis raging,” said Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. in New York.

Just as in 1997-98, emerging markets are becoming unmoored, fanning fears about global growth and financial market stability. The crisis back then eventually triggered the near bankruptcy of U.S. hedge fund Long-Term Capital Management and was only brought to an end when the Greenspan Fed cut rates.

So far, at least, the turmoil this time has not gotten that bad. There’s been little or no talk in the markets of financial stresses in the U.S. Big U.S. banks, in particular, are well fortified against market turmoil, having passed Fed stress tests earlier this year that posed a scenario of equity prices falling about 60 percent over the space of a little more than a year.

And while emerging markets are suffering, they’re still in better shape than then were in 1997-98, when a number of them had to turn to the International Monetary Fund for assistance, Paul Ashworth, chief U.S. economist at Capital Economics in Toronto, said in a report Monday to clients.

Close Call

The Fed decision on whether to raise rates next month probably was going to be a finely balanced one, even before the recent swoon in U.S. stock markets, Wright said.

Arguing for a move next month: the steady performance so far of the U.S. economy. Claims for jobless benefits are hovering around the lowest levels in four decades and employment has increased by 211,000 workers a month on average this year. The housing market is strengthening with sales of existing homes in July reaching the highest level since 2007.

“The fundamental backdrop in the United States still remains extremely sound, and if we put a lot of these market stresses behind us, then I think September is still a viable month,” said Tom Porcelli, chief U.S. economist at RBC Capital Markets LLC in New York.

Inflation, though, has shown no sign of picking up and remains well short of the Fed’s target. The central bank’s preferred inflation measure, which is tied to consumer spending, climbed 0.3 percent in the 12 months ended in June.

Jackson Hole

Inflation is the key topic of debate at the Fed’s annual economic conference in Jackson Hole, Wyoming, where world central bankers gather beginning Thursday. On Saturday, Fed Vice Chairman Stanley Fischer will discuss U.S. inflation developments. Yellen isn’t attending the event this year.

At their meeting last month, Fed officials said they needed to see “more evidence” that economic growth would be strong enough to raise inflation in the future, even as they said conditions for a rate increase were approaching, according to the minutes of that gathering.

The stresses in financial markets -- especially if they continue -- will weigh on both growth and inflation. Bloomberg’s U.S. Financial Conditions Index fell below zero Friday for the first time in three years, indicating market conditions are becoming restrictive of growth. The index is now at the lowest level since 2012, owing mainly to a surge in credit spreads and stock-market volatility.

Dollar Reaction

“Funds are going to flow into the U.S. and that will put upward pressure on our exchange rate,” added Robert Eisenbeis, chief monetary economist at Cumberland Advisors in Sarasota, Florida and a former Atlanta Fed research director. The stronger dollar, in turn, will depress import prices and make “it less likely” the Fed will hit its inflation target over time. Since Aug. 17, the greenback has actually declined 1.8 percent on the Bloomberg Dollar Spot Index, which measures its performance against 10 major rivals.

Yellen and her colleagues probably view the financial turmoil with “great trepidation,” said Roberto Perli, a partner at Cornerstone Macro LLC in Washington and a former Fed economist. “The Fed has a history of being cautious at times of market turmoil, and probably they will be cautious this time as well.”

For more, read this QuickTake: The Fed’s Countdown

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