The US Federal Reserve’s decision not to raise interest rates after the September 16-17 meeting of the policy-setting Federal Open Market Committee (FOMC) did not come as jolt out of the blue for economists and investors. The financial world, having grown tired of waiting for long, had already factored in either scenario: no change or higher rates.
The US central bank has long been waiting for evidence to ensure the recovery is strong enough to start raising the interest rate it held near zero after the 2008 crisis. But the Fed’s downbeat global view was largely influenced by a fragile global economic backdrop and troubles in China and other emerging markets.
The main concern over higher US interest rates is the sudden flight of capital - “hot money outflows” - from countries that are dependent on foreign financing. But governments in the developing world had better worry less about a US tightening than focusing on domestic policy changes to fortify their economies to weather external shocks. Many developing countries – especially in Asia – are in much better shape compared with how they were just before the Asian financial crisis of the late 1990s or the 2008 global crisis, argues Shang-Jin Wei, chief economist at the Asian Development Bank. India will probably do best among the 10 largest emerging equity markets after the Fed boosts rates, according to a Bloomberg survey taken before the Chinese yuan devaluation.
Fed officials have acknowledged that there could be unintended consequences for what they prefer to call a rate normalisation process, but leaving rates at zero indefinitely is not an option. They have tried to shift the discussion from the liftoff to the longer trajectory of gradual increases to reach the 3.75% level.
Though the Fed has now decided stay put, signs are a rate hike is still on the table for 2015. Three policy makers argued on Saturday for lifting rate before year-end, countering bets by many traders that the central bank will wait until 2016.
Fed chair Janet Yellen, however, is under pressure to guide an FOMC divided between those who feel the US economy has bounced back for a rate hike, and those who argue a weak global economy is a drag. The Fed also has been sending such seemingly contradictory signals as saying that markets should not influence monetary policy, but then reacting to markets; policy is data dependent and then declaring that a 5.1% jobless rate needs to drop further.
Some economists feel the much-awaited Fed liftoff could do more good than harm as higher US rates will send a clear message that the world’s biggest economy - and growth engine - is revving up again. Markets may also follow a higher-rate trail as long as the tightening is gradual.
The stakes are high and global, though. A mistimed start of normalisation by the Fed could see a further slowdown in the global economy with investors having to readjust to the taper and capital being sucked out of emerging markets.
