NEW YORK -- Seven years after the collapse of Lehman Brothers sent a shock wave through global markets, U.S. Federal Reserve Chair Janet Yellen and her colleagues may finally end the zero interest rate policy they put in place to contain the financial crisis.
As the Federal Open Market Committee weighs its next move at its meeting on Sept. 16-17, market watchers around the world are bracing themselves, wondering whether the U.S. and global economies are ready for tightening.
"I expect that it will be appropriate at some point later this year to take the first step to raise the federal funds rate," Yellen said July 10, which suggests the U.S. central bank is likely to move before the end of the year. The markets are now focused on whether it will do so after the meeting in September, October or December.
An Aug. 4 Wall Street Journal interview of Dennis Lockhart, president of the Federal Reserve Bank of Atlanta, attracted a lot of attention. "I think there is a high bar right now [for] not acting, speaking for myself," making his position clear that interest rates should be raised, adding, "It will take a significant deterioration in the economic picture for me to be disinclined to move ahead."
Lockhart is one of five regional bank presidents who are voting members of the FOMC this year. His remarks took many observers by surprise because he had been regarded as neutral.
Other bank presidents' positions are easier to predict. Hawks such as Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, support an interest rate hike in September, while Charles Evans, head of the Federal Reserve Bank of Chicago is a dove. He is likely to argue for delaying a rate increase until next year.
Jobs, jobs, jobs
Employment numbers figure heavily in the Fed's decision-making, and they are the most closely watched economic indicator around the world. Data released Aug. 7 showed U.S. nonfarm payrolls expanded by 215,000 on the month in July, the third straight month of rises exceeding 200,000.
The job market is improving. The unemployment rate for July came in at 5.3%, unchanged from the previous month. Although the latest data was not strong enough to make the case for a September interest rate hike rock solid, neither was it a sign that the U.S. economy is weakening.
Chris Rupkey, chief financial economist at the Bank of Tokyo-Mitsubishi UFJ, looking at the latest employment data, said: "The Fed is on track to raise rates for the first time since financial crisis at the September meeting."
All in the timing
This does not mean a September hike is a sure thing. There is one more key bit of data to consider before the FOMC meeting: the employment figures for August due out Sept. 4. In addition to maximizing employment, the Fed must also keep an eye on prices. It has set a 2% inflation target, but actual inflation is running about 1.5% and has fallen short of the target for nearly three and a half years.
Former Fed Chairman Ben Bernanke drew a fair amount of criticism for failing to prevent the financial meltdown in 2008, but he acted quickly in the wake of the crisis, drawing on his earlier academic research on the Great Depression. He introduced a zero interest policy and as soon as it was clear that this was not enough, launched three rounds of quantitative easing. That earned him the moniker "Helicopter Ben," based on a paper he once wrote in which he speculated that in the case of widespread deflation, one response might be to simply dump dollars out of helicopters.
Once the bond market stabilized, stock prices started picking up steadily. The Dow Jones Industrial Average returned to the pre-crisis level in the spring of 2013, bouncing back faster than employment.
Inflation remains tame and thanks to the Fed's aggressive monetary easing, fears of Japanese-style stagnation have died down. But price rises have been sluggish, partly because wages are climbing slowly and the job market is still slack. Hourly wages rose by 2.1% on the year in July, increasing at a far gentler pace than the 3-4% clip seen before the crisis.
This has led the International Monetary Fund to try to talk the Fed out of raising interest rates before the end of the year. The multilateral lender believes there is no need to rush. "Raising rates too soon could trigger a greater-than-expected tightening of financial conditions, or a bout of financial instability, causing the economy to stall," the IMF said in a statement in June. "This would likely force the Fed to reverse direction, moving rates back down toward zero, with potential cost to credibility," it warned.
Setting aside whether the IMF is in a position to lecture the Fed about credibility, there are serious worries about the effect of a U.S. monetary tightening on emerging economies.
In the foreign exchange market, the dollar is strengthening while currencies of emerging economies are weakening in anticipation of a U.S. rate hike. The big emerging economies are more stable than they were, thanks to their higher foreign reserves. But China, the world's second-largest economy, is on shaky ground, as are global stock markets. This adds a new element of risk.
The ultralow interest rates that have prevailed worldwide in recent years began in the U.S. as a response to the financial crisis. Yellen's ability to turn the page on that era will now be put to the test.