Fed has big­ger wor­ries than China

The Pak Banker - - OPINION - Mark Gil­bert

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. 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. "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.

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