Fed Has Bigger Worries Than China
Atlanta Federal Reserve President Dennis Lockhart acknowledged on Monday that collapsing Chinese stock markets, plunging commodity prices, and an intensifying currency war have complicated the central bank's decision about whether to raise interest rates. There are more fundamental reasons, however, why the Fed should be resisting its instinct to tighten policy.
Wherever you look in financial markets -- whether its breakeven rates in the U.S. government bond market (the yield gaps between vanilla Treasuries and those which compensate bondholders for faster inflation) or euro-denominated inflation swaps (a type of derivative used by pension funds to help ensure they have enough set aside to pay people's pensions) -- negative rates abound. That suggests consumer prices are more likely to slump than climb:
Moreover, there's accumulating evidence that monetary conditions in the world's biggest economy have already tightened. Paul Kasriel, the former chief economist at Northern Trust who now writes "The Econtrarian" blog, argues that "in recent months Fed monetary policy has become downright restrictive," even as the benchmark interest rate has remained at 0.25 percent.
As the Fed unwound its third round of quantitative easing, Kasriel argues, that tapering destroyed the "thin-air credit" that the central bank supplies to the financial system -- hence the shrinkage in the balance sheets of U.S. banks seen in the following chart.
Goldman Sachs also sees evidence that U.S. monetary conditions have already tightened. Goldman compiles a financial conditions index that offers a snapshot of the monetary backdrop by blending market rates, and the spreads between them, with what's happening in equities and currencies markets. That index suggests conditions have rapidly tightened:
That's not good news for the U.S. economy. Goldman economist Sven Jari Stehn said in a research report on Tuesday that current market conditions could knock as much as 0.5 percentage points off U.S. growth, with the "drag" rising to as high as 0.8 point by the end of the year. And if market turmoil deepens, that could exacerbate the slowdown.
Bloomberg calculates a different financial conditions index which tracks how much stress there is in U.S. markets, with a negative value suggesting financial conditions are tightening. Here's what that index has done in the past few days:
"The balance of risks is toward more financial instability, slower growth, disinflation and deflation," Harvard University professor and former U.S. Treasury Secretary Lawrence Summers said this week. "That's not a time to be raising rates." I agree -- and it's got nothing to do with what's happening in the Chinese stock market.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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