Can we pinpoint the root cause of our market instability?
U.S. Monetary Policy and Global Instability
The first half of 2015 has seen widespread speculation that the Federal Reserve would reverse the expansionary policy of the recent years and finally raise interest rates. Speculation has placed a higher probability of a rate hike occurring in September of this year. But as September beckoned, the end of August saw a meltdown in the global financial markets. The Volatility Index spiked to record highs, almost reaching 2008-2009 levels.
The multitude of factors causing global instability makes it virtually impossible to pinpoint the root cause of the havoc. The crux of the Federal Reserve’s dilemma is that without an accurate diagnosis of the market’s instability, an effective fix cannot be prescribed. Among the factors influencing the Federal Reserve’s monetary policy include the dramatic decline in commodity prices spurred by the collapsing Chinese markets, and the expansionary policies in Europe and Japan.
The decline in commodity prices, most notably crude oil, has thrown a wrench into the gears of emerging economies that rely heavily on exports. Indonesia’s ports are piling up with coal exports that are seeing a drop in demand. South African metal mines are shutting down and laying off workers. Russia’s oil dependent economy is also experiencing slowdowns. With emerging economies all over the globe slowing down, the Federal Reserve must take caution not to reduce global aggregate demand even further.
At the heart of the global slowdown of commodity exports is one of the world’s largest importers- China. The artificially propped up markets in China have begun to show signs of weakness, with the growth rate slowing from the mid-teens to near 7%. Accordingly, the Shanghai Composite Index has fallen almost 43% since its peak in June. The collapse has spurred an ambitious stimulus program from the People’s Bank of China, including multiple rate cuts and a lowered reserve requirement ratio that resulted in massive amounts of liquidity injected into the market.
As China struggles to keep pace with growth expectations, the Eurozone has continued to be mired in economic turmoil that is characterized by negative interest rates and an open ended quantitative easing program intended to combat the deflationary spiral. With the inflation rate currently a far cry from the ECB’s target of 2%, debt burdens and weak investments in the Eurozone are a looming headache that could reverberate into the U.S. economy.
Meanwhile, Japan’s perennial problem of deflation has emerged once again, with the inflation rate dropping to zero for the third time this year. With an aging population and an unsustainable amount of debt, Japan’s fiscal problems do not bode well for the economic health of the country that has seen contractions in the prior quarters of this year.
With a host of moving pieces to the increasingly complex puzzle, the U.S. economy has the dilemma of being out of step with the rest of the world in terms of the economic cycle. The strong fundamentals of the U.S. economic recovery, evident through improved labor market conditions and falling unemployment, demand that the Federal Reserve stop delaying the inevitable and react strongly to the global instability by raising the interest rates.
Changing the course of action with the backdrop of global instability will draw criticism of the central bank coddling the financial markets. But acting too aggressively to raise interest rates in the face of global turmoil can prove to be reckless. At such a critical juncture of financial history, it is clear that whatever decision the Federal Reserve makes will have far reaching effects all over the globe.