Fed Rate Hike: Why All The Fuss?

LONDON — Whrrrrrrrrrrrrrr!

Hear that?

It’s the sound of a PR machine going flat out.

One issue has hung over the market all summer.

We’ve had drama from Greece and China’s been a source of much volatility, but the one overarching question has been this: will the Federal Reserve raise interest rates on September 17?

With one week to go, the spin game has grown more intense.

In the Dove Corner we have such luminaries as the IMF, the World Bank and former US Treasury Secretary Larry Summers, urging the Fed not be rash and put rates up.

More recently though more hawkish voices have been making themselves heard.

Richard Fisher and Charles Plosser, ex-heads of the Dallas and Philadelphia Feds respectively, have warned the Fed not to wait too long to make its first rate hike in nearly a decade.

Even the heads of some emerging market central banks are suggesting the Fed should end the uncertainty and just get on with it.

Why is This Creating Such a Fuss?

Context is everything. If the Fed does raise its policy rate next week, it won’t raise it by much. In all likelihood it would go up from sub 0.25% to 0.5%.

That’s where the Bank of England is already. For all intents and purposes both central banks have been running zero rate policies for years. In and of itself a Fed funds rate of 0.5% makes little difference to anything.

The policy decision, however, makes the world of difference.

Why? Well, the short answer is to say it is symbolic.

A fuller answer would note that the Fed has historically tended to embark on what jargon fans call “tightening cycles”.

That’s several rate hikes in a row over a period of a few years, with the aim of keeping inflation and employment “on target”.

A decision by the Fed to raise rates would be seen as the beginning of a new tightening cycle. There are many who remain unconvinced the US economy is ready to withstand that yet.

The global economy meantime has just been hit by its “third deflationary wave” since the financial crisis.

This is no time to be taking risks with a rate hike, the doves say.

The Risks of Inaction

Thing is, there’s a risk to hiking rates and a risk to not hiking them.

As former Dallas Fed chief Fisher wrote in the FT this week, there’s a risk to the economy of acting too late.

“Every time the Fed has waited for full employment to be achieved before starting to tighten policy,” says Fisher, “it has ended up having to tighten so much that it has driven the economy into recession.”

One potential source of future pain is the $4tn of debt companies have loaded up on thanks to low borrowing costs. You can read Bill Bonner on that topic here.Then there are the risks to financial stability of holding rates too low for too long. Of course, we’ve been running those risks for years now. I suspect we’ve stored up plenty of trouble ahead.

Back to the Fed decision, and whether or not the US, the world economy and the financial markets are ready for a new tightening cycle.

As I see it, the argument against a rate hike is based on the idea the world remains in a weak spot.

It’s hard to argue with that. Especially if you consider that increased corporate borrowing will have helped improve the all-important economic data that make the US outlook appear relatively strong.

The trouble is, holding off on a tightening cycle may make the economy and the markets even further reliant on cheap credit, and even less resilient to higher interest rates.

The longer the Fed puts it off after going on about it so much, the more likely the market will conclude it won’t dare tighten.

A Mad Idea

Here’s a mad idea. What if they were to junk the idea of a tightening cycle altogether?

Hike rates a little bit, but accompany that with a barrage of blather (“forward guidance”, to use the jargon) about how the next move may actually be to lower rates again.

In this way, policy rates would become like terror alerts. A symbolic, largely meaningless variable to raise and lower whenever you want to send a signal and influence behaviour.

I’m not saying this will happen, and certainly not that it should, but it may be one way out of the corner Fed boss Janet Yellen has talked herself into. At least temporarily.

As for next week’s Fed decision, Jim Rickards has outlined his three most likely scenarios along with their investment implications.

Look out for that in tomorrow’s DR.

Until next time,

Ben Traynor
for The Daily Reckoning, U.K.

P.S. Be sure to sign up for The Daily Reckoning — a free and entertaining look at the world of finance and politics. The articles you find here on our website are only a snippet of what you receive in The Daily Reckoning email edition. Click here now to sign up for FREE to see what you’re missing.