It’s the biggest news of the season that isn’t news: The United States Federal Reserve has once again opted not to raise the federal funds rate amid fervent speculation by markets.
Reactions to the decision were mixed, with some, such as Richmond Federal Reserve President Jeffrey Lacker advocating a rate hike this month, while others can now breathe a sigh of relief. With the decision to keep rates steady, the domestic debate over a future hike continues. The debate and speculation is over something called the federal funds rate: a rate that the Federal Open Market Commission (FOMC) establishes as its target for overnight interbank loans. The FOMC aims for this target through open market operations — through the buying and selling of bonds. To make this decision, the Federal Reserve is charged with a dual mandate to maintain maximum sustainable employment in the US economy and to keep price levels steady. If inflation isn’t steady and at an appropriate level, the Fed isn’t fulfilling this dual mandate.
Decisions made by the Federal Reserve are like stones cast into a pond: Disturbances ripple outward, but they also bounce back to American consumers as changes in other economies affects the United States through trade. If we consider the Fed’s goals and how its latest decision may impact the global economy, the larger responsibility of the United States to global markets becomes apparent.
The federal funds rate is important chiefly because it impacts other interest rates, which in turn affect inflation. During the Great Recession, when the economy was doing poorly, the Fed reacted to the economic downturn in part by lowering the federal funds rate to a record low range of zero to a quarter percent. The current debate over when to raise interest rates is a response to improving economic conditions, especially higher employment. A raise is seen as desirable for two main reasons. First, the Fed needs to “reload” to a higher rate in order to have a mechanism for mitigating future crises. Second, the market’s expectations of future inflation should be kept tied to reality.
However, what made the decision not to act easier this time around was the recent fragility and volatility seen in international markets, especially China. Following highs in the Shanghai stock market in mid-June, the index lost around 40 percent of its value in a month. The Chinese government reacted in a panic, slashing interest rates, essentially banning short selling, and otherwise doing everything possible to avert the slowdown that could follow if consumers were spooked by losses.
Given the massive portion of US debt that foreign businesses, governments and consumers hold, international market signals are increasingly important. In the Bank for International Settlements’ (BIS) June 2015 annual report (which received a lot of coverage for its scathing critique of the “new normal” for central banks across the globe), much attention was also paid to the $9.5 trillion debt held outside the United States by non-banks alone, a 36 percent increase from pre-crash 2007 levels. That’s over half of the US GDP, tied up in the lives of many more people, businesses, and countries than the Federal Reserve is formally mandated to consider in its decisions. In emerging market economies especially, high growth has meant high interest rates, and so businesses have piled up cheap US debt — often a much more stable investment than their own governments’ debt.
With increased interest rates, free money starts to cost something. Oftentimes, however, businesses borrow money to invest in projects that yield good returns only under the conditions of easy money. While it’s true that countries like China have capital controls to raise the cost of dollar borrowing, multinational firms can borrow offshore. As a result, a lot of the largest companies with considerable reach into many different countries are holding short-term debt that has the potential to become poison whenever US policymakers decide. Indeed, several countries, including China, have credit gaps (the deviation of private sector credit from its long-term trend) above 10 percent. Beyond this threshold, historical data suggest that two-thirds of the time “serious banking strains” follow within three years. This is because, according to BIS, “an increase in interest rates would push up debt service ratios in other countries as well, especially in Asia.” Chinese businesses will thus face additional headwind when, for example, long-term investments financed with cheap money are not producing returns yet even as interest payments grow. This means lower profit margins, which will likely be reflected in stock markets, employment, and consumer demand.
Interest rate hikes also affect exchange rates. Gita Gopinath of Harvard University presented a paper on the effect of rate changes on foreign economies at the Fed’s Jackson Hole conference over the summer and found that “exchange rate appreciations…lower mark-ups and hence proﬁts [for international firms].” As mentioned, one of China’s responses to its stock crash has been to allow the Renminbi to weaken against the dollar in order to bolster the economy. Essentially, a US rate hike would work to negate the efforts of the People’s Bank of China at a time of particular instability.
In other words, it’s not going to be easy for emerging economies like China to continue their growth trajectory when the rate hikes happen. Given the size of American overseas influence, the United States has an obligation to take into account international stakeholders, not least because doing so is in its own best interest: In a world of increasing interconnectivity, hurting firms and consumers in other countries amounts to also hurting US firms. So, although not a part of the dual mandate of the Federal Reserve, its decision to look overseas as well as at home in deciding not to raise rates is justifiable in light of the potential domestic impact of foreign volatility.