Global reasons for Fed caution on interest rates

Greg Nash

When the Federal Open Market Committee (FOMC) next meets June 15-16, it will be tempted to raise interest rates for a second time this cycle. After all, domestic indicators are now pointing to a tightening in labor market conditions and to incipient price inflation.

{mosads}Before rushing to do so, however, the Fed might want to take into consideration four global factors that might argue in favor of forbearance at this delicate juncture for the world economy. Those factors have the potential to seriously roil global financial markets that could in turn very much cloud the U.S. economic outlook.

Among the most immediate global issues that should be giving the Federal Reserve pause is the forthcoming “Brexit” referendum on June 23. A vote in favor of Brexit would almost certainly trigger a sterling crisis that could highly unsettle global currency markets. This is especially the case considering that this referendum is being held at a time that the United Kingdom is running a record external current account deficit of 7 percent of gross domestic product (GDP). The financing of that deficit depends critically on capital continuing to flow into the U.K. rather than on capital leaving it. Sadly, capital flight is all too likely to occur should the U.K.’s future relationship with Europe become shrouded in uncertainty.

With the Brexit opinion polls suggesting that this referendum is too close to call, one would think that it would be imprudent of the Fed to raise U.S. interest rates one week before a referendum that could shake global markets.

The Fed might also want to consider how an interest rate hike now might affect capital flows to the emerging markets in general and to the troubled Brazilian economy in particular. Brazil, the world’s seventh largest economy, is at present experiencing its deepest economic recession since the 1930s and an extremely difficult domestic political situation. It is also now suffering from a ballooning budget deficit that has reached 10 percent of GDP and that is putting Brazil’s public debt on an unsustainable path. The last thing that Brazil needs now at a time of considerable economic and political uncertainty is a hike in U.S. interest rates that might hasten the return of capital to the United States and that might complicate Brazil’s ability to finance its budget deficit.

Similarly, one would think that there is the very real risk that a U.S. interest rate hike now could unsettle China, the world’s second largest economy at the very time that the Chinese government is attempting a difficult transformation of its economy. It could do so by causing the U.S. dollar to appreciate against the Chinese renminbi, thereby again precipitating capital flight from China as occurred on a very large scale in the wake of the August 2015 renminbi depreciation. In that context, it has to be of concern that China currently still has around $700 billion in short-term external liabilities that could very well be repaid in the event of a further depreciation in the renminbi. It also has to be of concern that a renewed Chinese depreciation could heighten the risk of a global currency war.

Yet another global factor that one hopes is on the Federal Reserve’s radar screen is the scheduled October Italian referendum on constitutional reform in that country. That referendum is all too likely to be turned into a vote of confidence on Prime Minister Matteo Renzi’s government. It would seem to be imprudent to dismiss out of hand the possibility of a negative vote in that referendum. Such an outcome would almost certainly plunge Italy into an economic and political crisis that could very well reignite the European sovereign debt crisis.

With all too many reasons for concern about the global economy and with likely domestic economic uncertainty ahead of the U.S. presidential election, one has to ask, what is the Fed’s rush to hike interest rates now? Might it not be more prudent for the Fed to wait before raising rates, to allow time to get a better assessment of the global risks that now confront us?

Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.

Tags Brazil Brexit Britain China Currency emerging market Fed Federal Open Market Committee Federal Reserve FOMC Interest rate Italy U.K. United Kingdom
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