The Cable

Will Fed Chief Janet Yellen Ignore China and Follow Through on an Interest Rate Hike?

Will China's decision to devaluate its currency cause Fed chief Janet Yellen to balk on a rate hike?

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When Federal Reserve chief Janet Yellen speaks publicly, investors and policymakers around the world carefully parse her words for any indication that U.S. interest rates, which have been near zero since 2006, would rise. In July, she held off, leading many to expect the “liftoff” from zero would come in September. But a lot has changed since then.

China has devalued its currency, the renminbi, for three straight days, a step it had avoided for more than two decades. It’s a sign of broader economic weakness in the world’s second-largest economy, and it comes on the heels of a 30 percent Chinese stock market crash this summer and an 8.3 percent year-over-year plunge in July exports.

This extent of Chinese weakness has rippled around the world, spooking emerging markets like Colombia and Brazil, which rely on Chinese consumers to buy their products and commodities, and Germany, China’s fourth-largest trading partner. Firms there are now panicked over what one German publication called the “China effect”: A slowdown in China could translate to a slowdown for German manufacturers, which represented 22 percent of the country’s GDP from 2010 to 2014, according to the World Bank.

This all makes the United States an oasis of calm in a sea of turbulence. The American economy has enjoyed six years of slow but steady economic growth. And a big reason for this is the Fed’s rate policy, which was put in place in 2006 to help the United States emerge from the Great Recession. Right now, it’s free for companies and investment firms to borrow from the federal government.

Yellen and her advisors now must decide whether to take a calculated risk. The Fed could raise interest rates and trust that the American economy is strong enough to shed the zero rate policy. She could also play it safe and keep the cost of borrowing where it is. But continuing to make it free to borrow, when she has long been expected to raise rates, sends a clear signal: She’s not confident the United States can withstand a slowdown in China and its fallout around the world.

“The Fed needs to carefully consider whether pulling off the Band-Aid would reopen a wound that won’t easily close again,” Donald Kohn, who served on the Board of Governors of the Federal Reserve from 2002 to 2010, told Foreign Policy on Thursday.

For months, investment heavyweights like Janus Capital Group’s Bill Gross, who manages the $1.5 billion Janus Global Unconstrained Bond Fund, have been urging Yellen to take the risk and increase rates. But according to Greg McBride, chief financial analyst at Bankrate.com, the Chinese devaluation has changed the game.

“The Fed is waiting for world peace and harmony,” McBride told FP. “They’ll never raise interest rates. But they have to get started.”

He said it’s not the initial rate hike that would negatively impact the economy — it’s those in the future that could eventually lead to economic peril. “It’s the first dusting of snow you get in the fall. It signifies winter is coming; the seasons have changed,” McBride said.

He cited the 17 times the Fed made it more expensive to borrow from 2004 to 2006. That ultimately helped create a housing bubble when people borrowed more money than they could afford. When the bubble burst, it started the worst economic downturn since the Great Depression.

The shock that would accompany a new rise in interest rates, on top of concerns about China, could cause Yellen to rethink her strategy once again, McBride conceded. But he added, “If China has a recession, it’s going to hurt all of us,” regardless of U.S. interest rates, he said.

When asked if Beijing’s devaluation strategy would be enough to reverse China’s slide, McBride said: “I don’t know, but I hope so.”

Photo credit: Chip Somodevilla/Getty Images

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