JACKSON HOLE, Wyo. — While the U.S. economy is healthy enough for the Federal Reserve to consider ending the extraordinary cash infusions it has pumped into world markets since 2008, such a change of course would pose big challenges for Europe’s debt-strapped economies and for many of the world’s developing countries.
Thanks to the Fed’s extraordinary ministrations, the U.S. economy has achieved “escape velocity” with solid job growth this year and is ready to be taken out of intensive care and recover on its own, said Paul McCulley, chairman of the Global Interdependence Center’s Global Society of Fellows, an economic group affiliated with the Philadelphia Federal Reserve Bank that held its annual economic conference last week.
“It has worked. My hat is off to the Fed” for nursing the economy through the “acute” stage of a monumental liquidity crisis that threatened to plunge the U.S. into a deep depression after the 2008 financial crisis, he said.
Under Chairman Ben S. Bernanke, the Fed for the first time experimented with trying to revive the financial markets and the economy in the aftermath of the crisis by purchasing more than $3 trillion worth of U.S. Treasury and mortgage bonds, forcing interest rates to record lows, which helped heal the economy but also created the conditions for a potentially destructive bubble in the bond market, he said.
The Fed, having achieved success, now is debating plans to move slowly and cautiously to end the $85 billion of bond purchases it has been making each month and gradually normalize the level of interest rates. Mr. Bernanke said last month that the central bank could start paring the purchases at any time, especially if the job market continues to improve. A growing number of Fed officials say they want to end the program this year.
Although the Fed’s move toward normalization signals a victory for the U.S. economy, financial markets around the world face major adjustments as the Fed slowly withholds and then withdraws the massive infusions of cash that have sent interest rates to unprecedented lows in the U.S. and in countries such as Turkey, South Africa and Brazil.
World markets react
The mere discussion last month by Mr. Bernanke and other top officials that the Fed may start phasing down bond purchases sent U.S. interest rates soaring by a full percentage point and set off tumult in world stock and bond markets. The brunt of the adjustment was felt by Europe’s weakest economies and emerging markets, where stocks plunged by 10 percent on average in the past month.
A substantial portion of the cash pumped out by the Fed in the past five years was invested in the emerging markets, Catherine Mann, a finance professor at Brandeis University, said at the conference.
“The influx of cheap dollars into emerging markets was not healthy. It overinflated Brazil and China made them grow too fast,” she said. “A lot of money went into Africa and the frontier markets” that are just starting to develop modern economies.
Now, these developing economies face the “challenge of trying to even out their business environment” while interest rates are rising sharply in reaction to the Fed and as their own economies are grappling with the recession in Europe and economic troubles elsewhere in he world, she said.
“Foreign capital will come back to the U.S. when the dollar appreciates and interest rates rise” in response to the Fed, she said. “It’s all coming home. That will be a good sign for the U.S. economy.”
But the transition will be much more difficult for emerging nations that depend on exports and “hot money” flows from the U.S. and other foreign investors to fuel investment and growth. They have not developed the kind of rich, consumer-led economy of the U.S., which can keep growing without outside help, she said.
“Without the ‘one night stand’ money” made available to investors by the Fed’s easy-money policies, she said, “it will be very challenging for an emerging market economy” in the months ahead.
Debt-stricken European countries such as Greece, Spain and Italy also are facing the hardships of significantly higher interest rates in the wake of the Fed’s plans, said Axel Weber, chairman of Swiss banking giant UBS.
“For the sake of the European periphery, I am concerned,” he said at the conference. “We’re seeing the re-emergence of pressure in Europe as a result of the normalization of interest rates by the Fed.”
The only hope for the worst-off European economies, which have fallen into deep recessions with unemployment rates as high as 27 percent as a result of the Continent’s sovereign debt crisis, is that the European Central Bank will step in and take extraordinary measures such as those used successfully by the Fed, said Julian Callow, chief international economist at Barclays Bank.
Chinese growth in question
Perhaps the biggest danger is the let-down for China as it struggles to cope with the European recession and higher global interest rates. That could be the most troubling for the world economy, Mr. Callow said, because it was robust growth in China that buoyed global economies in the aftermath of the 2008 crisis.
“Nearly half the growth in the world economy in the last five years came from China,” and in particular was spawned by a frenetic Chinese building binge on skyscrapers, factories, roads, bridges, airports and all other manner of infrastructure that required massive imports of basic materials such as copper, coal and iron, he said. China’s boom spurred an economic boom in commodity-producing nations from Australia and Canada to Peru and Brazil.
Those booms are over, and China could face a destructive real estate market collapse and financial shake-up after its overheated building boom that could reduce growth to paltry levels there and start to threaten global growth, Mr. Callow said.
“I’m worried that China could slow to 3 percent,” down from the double-digit annual growth rates China took for granted for decades, he said.
Michael Drury, chief economist at McVean Trading & Investments, agreed that with growth averaging from 0 percent to 2 percent in the Eurozone and the U.S. for the foreseeable future, growth in the world economy hinges on a revival in China, and the prospects are not good.
He said growth already has fallen to between 5 percent and 6 percent in China and could go lower as the government’s efforts to stimulate the economy with more debt-financed spending on infrastructure are producing feeble results.
“The basic problem in China is they’re in a classic middle-income trap,” he said. Having attained a modest level of incomes between $4,000 and $5,000 per person through rapid industrialization, China’s fast-rising wages are impairing the country’s competitive edge, but its consumers still do not have enough purchasing power to keep the economy growing on their own.
On top of that, “they mishandled the stimulus. All they got was a massive inflation and an increase in wealth at the top,” he said. “I would strongly suggest that you don’t invest any money in the Chinese stock market. Even the Chinese are trying to get their money out of the country.”
Fed focuses on U.S. economy
Worries about growth in Europe, China and the rest of the world do not appear to be much on the minds of Fed officials as they debate how soon to taper off their purchases of bonds.
James Bullard, president of the St. Louis Federal Reserve Bank, said he is assuming and hoping that the recession in Europe will end soon while growth in China will remain between 7 percent and 8 percent.
“There’s some risk of a broad turndown” in global growth as a result of the Fed’s actions, he said. Mr. Bullard has urged caution at the Fed not because of weak global growth but because he thinks the Fed could be jumping the gun and assuming that growth is healthier in the U.S. than it actually is.
U.S. growth, in fact, has averaged only 1 percent in the past three quarters, despite the Fed’s bond-buying campaign, and may not pick up to more solid rates of more than 2 percent as expected by a majority of Fed members next year, he said.
Meanwhile, inflation in the U.S. has declined to the 1 percent threshold below which the Fed considers it to be dangerously low, he said. For that reason, Mr. Bullard said, the central bank should hold off any change in policy until it sees evidence of more solid growth.
Mr. Bullard said he is confident that Mr. Bernanke agrees that the evidence of economic recovery must be more convincing before the Fed acts on its tapering plans.
Charles Plosser, president of the Federal Reserve Bank in Philadelphia, is among of a growing chorus of Fed officials calling for a quick end to the easing programs. He said he does not think the economy needs any further aid and the dangers of keeping such loose money policies in place can be ignored no longer.
“The economy hasn’t exactly boomed because of it,” he said, while the prospects for further major disruptions in global stock and bond markets are growing.
“It’s the law of unintended consequences, if we leave interest rates too low for too long,” he said. “It’s going to be a long, steady, slow slog toward recovery” no matter what the Fed does, he said.