US stock market correction worrisome for the Fed, but will it act?

US stock market correction worrisome for the Fed, but will it act?

The smooth ride of the last four years in US equity markets is over, and traders’ old companion, volatility, is back. How much will the Fed take notice?

Before this week, It had been nearly four year since the last correction in the US stock market. Now, the tangled combination of low oil and commodity prices, a weakening Chinese economy, and prolonged concerns about high valuations of US stocks, has caused a correction. What looked like an encouraging start to Tuesday quickly devolved into another down day, solidifying concerns that the stock market is linked enough to the real US economy to cause wider worry.

A recession in the US is still exceedingly unlikely, however, with data points from the housing market and consumer spending showing relative strength. But for many US companies, especially ones with large weightings in US stock indexes, like Apple, the slowing on the other side of the world is cause for concern.

What has been driving as much as half of the world’s growth over the last decade is fizzling more quickly than most had believed, and if that weren’t enough, the Chinese government’s attempts to stimulate the economy by weakening its currency will be yet another headwind for US economic growth.

It’s worth noting that although disappointing data points from China have been stacking up for some time, culminating in the People’s Bank of China’s devaluation two weeks ago, there was not one news item that served as a clear catalyst for the collapse that started last Wednesday. Instead, the rout seen since last Wednesday has been less about knee-jerk reactions, and more about digesting the entirety of the situation.

Either way, the market has reached levels of volatility not seen since 2011, and the so-called ‘dead cat bounce’ on Tuesday was unconvincing. As the market situation becomes a larger issue in the US, it will become more difficult for the Fed to ignore as it makes its next interest rate decision in September.

Unlike China’s ad hoc attempts to slow the bleeding from the stock market, the Fed will be measured and systematic. In the end, the Fed is not likely to change course because of a stock market correction. Instead, it may change course because it shares the same concerns about the world economic outlook as spooked traders.

The Fed’s September rate hike will be delayed

The Fed is not in the business of pleasing equity markets. Of course, in the case of quantitative easing, financial markets were used as a tool to try to boost the real economy — but pumping up stock prices was only a part of a larger policy mechanism. The opposite is not true, either: the Fed would not be likely to take an action that will unduly burden markets unless it was crucial to the implementation of its long-term policy goals.

Larry Summers and Paul Krugman both vociferously argued against the Fed raising rates in September before the stock market correction, and both are reaffirming their stances now. They, along with Mohamed El-Erian, essentially argue that despite a relatively strong US economy, the dramatically weakened international economy joins low inflation to tip the scale against a rate hike.

Notice that none of these concerns are about the stock market; setting monetary policy based on asset prices is generally seen as irresponsible. Low inflation and sputtering emerging markets also happen to be the concern of equity investors.

At this point, it appears that those worries will prevent a September hike from occurring. Previously, the Fed looked primed to raise rates in September, even though there was not a pressing need to. Removing the psychological barrier of the First Rate Hike, while still following a slow ramp of increases over the subsequent few years, was important for the Fed.

Now, however, the asymmetric risks associated with raising rates are more apparent than ever. Waiting to raise rates one FOMC meeting too long would, in the worst-case scenario, cause inflation to rise above 2% for a short period, while raising rates too early could derail the US economy. With Chinese devaluation strengthening the dollar (which was already a concern of economists) and Chinese demand slumping, raising rates is even less attractive.

December is now looking like the month the Fed will raise rates. The shock and awe of the last few weeks will have time to wear off, the US economy will have been able to solidify its position, and inflation will have an extra few months to creep up towards its 2% target.

Add to that comments earlier this week from Atlanta Fed President Dennis Lockhart, indicating that 2015 is still the year to raise rates. Further, the FOMC meeting in October is an unlikely time for such a momentous occasion, since there is not a scheduled public press conference by Fed Chair Janet Yellen.

Categories: Economics, North America

About Author

Alex Christensen

Alex is an Editor at Global Risk Insights, who also currently works in investment research. His work on political risk and economic policy has appeared in many forums, including Business Insider, Seeking Alpha, & The Emerging Market Investors Association. He holds a Master’s in Economics from the London School of Economics and BA from Washington University in St. Louis.