The Fed’s Great Miscalculation

The Federal Reserve never seems to learn from experience. On December 16, 2015, it chose to raise interest rates for the first time in seven years, thereby giving the all-clear signal about the US economy. Yet with each passing day, it seems that the Fed’s decision will prove to have been a monumental mistake as storm clouds gather over the global economy.

While the global economy might not be headed for another 2008-style crisis as George Soros is now suggesting, it looks very much like it is headed for a repeat of something like the 1998 Asian and Latin American crises. By now one would thought that the Fed might have learned that the US economy is not an island immune to storms abroad and that the US economic recovery could quite easily be derailed by external events.

At the heart of the Fed’s most recent policy judgment error is its failure to recognize the tremendous distortions that have been wrought on global financial markets by years of unusually low interest rates and massive Fed quantitative easing. In particular, the Fed seems to be oblivious to the fact that over the past five years its policies have been a primary factor in a super-boom in international commodity prices, a flooding of emerging market economies with capital inflows, and the pricing of risk assets like high-yield US bonds at levels that did not reflect the underlying default risk.

Strangely, in deciding to raise interest rates last month, it seems that the Federal Reserve has not noticed that the music in the global financial markets has stopped. In particular, no one seems to have alerted the Fed to the fact that major international commodity prices like oil have now plunged by 70 percent, thereby causing a major headache for the commodity-dependent emerging market economies and the US shale oil industry.

Nor does it seem that the Fed has been alerted to the fact that the earlier massive capital inflows to the emerging markets has turned to an outflow, which has caused the currencies of countries like Brazil, Russia, and South Africa to approximately halve in value. Even more difficult to understand is the fact that the Fed seems also to be turning a blind eye to the problems closer at home now surfacing in the US high-yield market in general, and in the $200 billion loan market to the US shale oil industry in particular.

Experience from the Asian and Latin American crises in the late 1990s should have taught the Federal Reserve that sharp moves in exchange rates and in international commodity prices make it difficult for companies and countries to repay their debt. This lesson would seem to be all the more pertinent today when we know that the emerging market corporate sector is drowning in debt. Indeed according to the Bank for International Settlements, emerging market companies’ total debt now currently exceeds $22 trillion, while the US dollar-denominated debt is around $5 trillion.

Warren Buffet has famously said that when the tide goes out we find out who has been swimming naked. Sadly, the international credit market tide now seems to be going out and we will soon find out which were the financial institutions in the industrialized countries that lent so imprudently when the music was still playing to the emerging market economies and to the US shale oil industry. We will also find out when the Federal Reserve inevitably backs down from its current projections that it might raise interest rates 3 or 4 times this year that the Fed too has been swimming naked.

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.

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