One of the first things I learnt on moving from the International Monetary Fund to work as a macroeconomist at a Wall Street investment bank was how fickle international bond traders could be. Literally the day after I might have explained to a bond trader the fundamental structural weaknesses of an economy, he would ask me whether I still subscribed to my view. And he would do so even though there was absolutely no material new information that might warrant a change of opinion.
Looking at Janet Yellen’s Federal Reserve, one has to wonder whether the same might not be said of the Fed in relation to its views on the global economy. This is especially the case judging by how many times it has changed its view on the state of the global economy in such a short space of time, despite the lack of any material change in information about the underlying weakness of the global economy.
To illustrate this point, in September 2015, the Fed cited a weak global economy as the reason not to raise interest rates, only to change its mind in December 2015, when it finally raised interest rates for the first time in eight years. Then in early 2016, as global financial markets swooned, the Fed again fretted about the state of the global economy. It did so only to change its mind on the subject at its latest meeting as global financial markets regained their poise.
The truth of the matter is that despite the many changes in the Fed’s assessment of the world economic outlook, two factors should have kept the Fed concerned about the potential for the global economy to adversely affect the US economic outlook. The first is that the world economy is and will continue to be drowning in debt for the foreseeable future. The second is that the world economy will continue to be characterized by an unusually large number of risks for the remainder of the year.
That the world is drowning in debt can hardly be a matter of dispute. Indeed, a recent McKinsey report correctly noted that the global debt level today was significantly higher than it was on the eve of the 2008-2009 Great Economic Recession. Of particular concern has to be that in the short space of six years, corporate borrowing in the emerging market economies has more than doubled to $23 trillion, of which as much as $5 trillion is in U.S. dollar-denominated debt.
It also is hardly reassuring that over the same period China’s non-financial private debt has increased by as much as 90 percent of China’s GDP, while sovereign debt to GDP levels in highly indebted countries like Japan and Italy keep rising to new record highs.
These high debt levels would seem to expose the global economy to considerable risk of a financial crisis particularly at a time when the global economy is characterized by as many fault lines as it is today. Among the more immediate of these fault lines is the risk that the United Kingdom might vote to leave the European Union in its referendum at the end of June, or that Greece is finally forced to exit the Euro. No less serious are the risks that China is forced to further depreciate its currency to contend with its capital outflow problem, that the Brazilian political and economic crisis might deepen, and that Japan’s appreciating currency might tip that country back into recession and deflation.
One would hope that in the period ahead the Fed will form its own consistent view on the global economic outlook, rather than be guided by the vagaries of the financial markets as it seems to have been the case until now. A more serious assessment of the global economic risks would likely minimize the danger that the Fed will prematurely hike interest rates again.
Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a Deputy Director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.