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Global economy at risk of financial ice age as US Fed decides on rates

The global economy is crying out for additional stimulus not policy restraint from the United States amid rising financial market uncertainties

PUBLISHED : Sunday, 13 September, 2015, 6:20pm
UPDATED : Sunday, 13 September, 2015, 6:20pm

This week the US Federal Reserve holds the world's fate in its hands. Global financial markets remain in thrall to the Fed's policy decision on Thursday on when to tighten interest rates for the first time in over a decade.

It could mean the world of difference on whether global equity, bond and currency markets sink or swim in the coming months.

The world economy is crying out for extra stimulus just at the moment the Fed is considering a dramatic U-turn in monetary policy. The downturn in global growth prospects, the slowdown in China's economy and rising financial market uncertainties make a very urgent case for the Fed to do nothing on rates until the outlook radically improves.

Market fear gauges like the Vix volatility index, which shot up to a four-year high last month, suggest financial confidence is at a low ebb.

Recent stock market upheavals could easily turn into a full-blown crisis - the last thing the global economy needs or the Fed wants at this stage.

The Fed is clearly keen to "normalise" US monetary policy after seven years of super-loose settings, but it is playing with fire. Even a small 25 basis point increase in benchmark rates could set off a chain reaction of much tighter US monetary conditions later on.

Once the Fed pulls the chocks away to higher rates the cost of credit will start to rise for consumers, companies and investors. Higher rates will also bring the 35-year bull market for US bonds crashing back to earth, forcing up yields and pushing up longer term lending costs for borrowers. This could pose a major blow to economic confidence.

Even a small technical correction in the US bond market could see long-term yields bouncing back to pre-2008 crisis levels over 5 per cent. US consumers would be squeezed by rising mortgage borrowing costs with the cost of raising capital becoming much more expensive for businesses.

Higher US rates and yields will mean an even stronger US dollar at a time when US manufacturers can least afford it. Over the past year, the dollar's index against other major currencies has risen around 20 per cent, which is the monetary equivalent of short-term interest rates rising by 5 per cent. That alone poses a mighty squeeze on the economy.

The era of cheap and easy credit is coming to an end and the economy will pay the penalty. Six years of strong economic recovery in the US could go up in smoke quite quickly. Economic growth of 3.7 per cent in the second quarter could easily have been the high water mark.

It is not just the US that will suffer headwinds. Contagion effects will quickly spread through to other economies, considering the sensitivity of global growth expectations to higher US rates.

Emerging markets also remain highly vulnerable to a reversal of capital flows if the threat of tighter US monetary policy leads to a reassessment by investors of higher risk investments.

Thankfully the odds suggest a one in three chance of the Fed raising rates this week, but the threat of higher rates will maintain a strong presence. A December increase still seems a high probability, so global markets are not off the hook for long.

The threat of higher US rates is just one piece of the jigsaw. A greater danger for markets is the risk the Fed starts to unbundle its huge stockpile of quantitative easing bond purchases at some stage.

The Fed's accumulation of QE assets has plateaued out at about US$4.5 trillion. If there was any hint the Fed was starting to sell bonds, it would be game over for markets.

Fortunately, there are other countries that are stepping up to the mark with lower rates and extra QE measures. Thirty-seven nations have cut rates so far this year and the European Central Bank has already announced it is ready to step up its QE programme if need be. Canada could soon be next in line to embark down the QE route.

The trouble is that QE has lost its novelty value. There is already a world glut of QE liquidity, equity markets are over bloated by synthetic money and at risk of deeper implosion if it fails. Global confidence is on a knife edge and a second wave of the financial crisis beckons. We could head into a new financial ice age unless the Fed makes the right decision this week.

David Brown is chief executive of New View Economics