The recent market jitters have a lot of people saying that the Fed might have made a yuge mistake by raising rates. I've been a vocal proponent against raising rates, but I am not convinced this was a policy error (just yet). The risk/reward doesn't look great in a world where the US economy is fairly weak and global growth is clearly slowing. Here's my thinking:
- The risk with rate hikes is creating an extreme divergence in global policy approaches where the US Central Bank - the world's most important central bank - is tightening policy into a global slowdown. The worry is that this exacerbates problems in foreign markets by increasing capital outflows, puts further upward pressure on the dollar, dings commodities, exacerbates foreign denominated dollar debt problems, etc. In the end, a sharp tightening could come back to pull the US into the global recession hole.
We're only one rate hike into this cycle, so let's not get too worked up. 25 bps isn't going to derail the global economy after all. But the Fed has to be careful moving forward here. It has the unenviable task of trying to manage domestic risks with foreign risks. Based on some of Janet Yellen's recent commentaries, I think she is probably more worried about financial instability than inflation or unemployment (both of which are obviously not problems). She's wary of being the next Fed Chair to sit around while asset bubbles blow, only to later find out that these bubbles caused yuge problems.
So, what we're going through right now might actually be the exact type of thing Janet Yellen wants to see. The US economy is doing okay; a few rate hikes aren't going to kill global growth, but they might be enough of a signal to dampen some of the enthusiasm in financial markets. As Matt Klein has noted, the Fed is simply trying to atone for its 1998 mistake. I think that's a reasonable assessment. So, maybe the Fed is trying to avoid some of the irrational exuberance we have been seeing in certain markets. If recent high yield bonds and broader stock declines are any sign, then maybe the Fed is achieving exactly what it would like to? And in the long run, that might not be all bad... Still, the Fed has to be careful here. It's pouring tiny amounts of gas on a global fire right now. Its actions this year could amount to pouring buckets on it (4 rate hikes would amount to at least a bucket, in my view). The Fed should tread carefully and very slowly.
* Yuge is a word not commonly recognized in most modern dictionaries, but derived from the Donald Trump dictionary. It loosely means "larger than huge".