For Now, The Fed's New Normal: Preserve the Old Abnormal

Forget about whether Serena Williams will make history in the U.S. Open for a moment; there is a bigger question hanging over the head of another powerful woman. In the run up to the meeting of the U.S. Federal Reserve on September 17, the "Will she? Won't she?" game is in full swing. Federal Reserve Chair Janet Yellen skipped the late August Jackson Hole confab of the central banking elite and assorted economists - a wise choice, since her every gesture or word or tone would be parsed and analyzed as to whether the Fed will raise the benchmark interest rate to more "normal" levels. It has been an unprecedented period of seven years of close-to-zero interest rates after the Fed took action following the 2008 crash. In a recent interview, Reserve Bank of India Governor, Raghuram Rajan cautioned: "If you are not careful about the volatility you are creating, the others have to respond and everybody is worse off." He had predicted the market conditions that culminated in the 2008 crash 10 years ago, only to be ridiculed as a Luddite. It would be wise for Fed officials to pay attention to him this time around.

To be clear, interest rate increases by the Fed profoundly affect the American economy, but they have even more complex repercussions worldwide, and in emerging markets (EMs) in particular. A rate hike would likely lead to a stronger dollar, causing global investors to park more of their money in the US, instead of in EMs. This, in turn, could affect their currencies, exports and even employment levels. With some exceptions, such as India, EMs as a class look more fragile than they did even a year ago. They would have to build up reserves as a cushion against any potential fallout from the Fed's actions. This would lead to them decreasing demand for goods from the US and elsewhere. Policy leaders' advice to the Fed in recent weeks has been mixed. While central bankers in Indonesia and Mexico have advocated a rate hike and getting past all the uncertainty, the chief economist for the World Bank, Kaushik Basu has made a case for keeping the hike on hold.

The debate over the pros and cons of a rate hike point to some central dilemmas for central bankers. Three major uncertainties will give the Fed reason to take a deep breath before making any decisions.

For one, US policymakers have been taken aback by the persistence of low inflation. Inflation was still running at just 1.2 per cent a year -- well below the Fed's target of 2 per cent. It is useful to recall that the Fed has been tasked by Congress to maximize employment and maintain stable prices. Despite the steadiness of the post-2008 recovery, wage growth in the US has so far been modest.

Couple this with the disappointing jobs growth numbers from September 4, and it is not unreasonable to expect that there is still room to push towards the twin goals of maximum employment and price stability. A premature rate hike could run the risk of halting that process.

In addition to the present, the future is shrouded in macroeconomic and geopolitical unknowns. There is continued downward pressure on oil prices. Add to that the sharp slowdown in China's economy, and we can expect further declines in commodity prices. This means there will be further risk that the Fed will not make its inflation target. In such scenarios, an argument can be made for a return to further monetary easing, rather than a rate hike.

A third uncertainty source is, of course, China, and, by extension, other EMs. China's debt, at $28 trillion in 2014, is 282 percent of its GDP. The Shanghai index dropped dramatically, the government devalued the renminbi and cut interest rates. With falling commodity demand from China, the currencies of the major commodity-suppliers to China -- South Africa, Brazil, Indonesia, Russia -- have been simultaneously hit. These are also countries with severe institutional voids and poor political stewardship. But with EMs producing close to 40 per cent of the global output, a further slowdown in these economies, triggered by higher interest rates in the US, risks contaminating the entire world economy. With the EU and Japan struggling, the last finger in the global economic dike is that of the US. Pulling that finger out to see which way the wind is blowing could present many perils.

In sum, there is a case to be made that the best the Fed can do for its new normal after its upcoming September meeting is to preserve the old abnormal -- keep the rate low.

Of course, there are arguments that can be made in favor of a rake hike, even if it is a modest increase. First, it takes time for such interventions to translate into effects in the real economy, so what should matter are the outlooks for the unemployment and inflation figures rather than their present state. Second, there is a real problem with timing. If the Fed does nothing in September, it is difficult to make such announcements in December prior to the key season for consumption spending, which would leave the Fed with no option but to make an announcement during the most active phase of the presidential election season in 2016 - an option that is not desirable. Third, it is reasonable to be concerned about the free ride the low-rate regime gives to Wall Street and the fat cats of the banking system.

On balance, for now, the argument for keeping rates where they are is stronger. There is far too much risk of volatility and the structural weakness in the global economy makes it likely that the negative effects would be amplified and last even longer, despite the U.S. economy being for now on more solid ground. It just doesn't feel right. I know this isn't precision engineering, but monetary engineering is not precise, no matter how many complex models are applied to the analysis of decisions. I would urge Janet Yellen and her Fed colleagues to stick to status quo.

Bhaskar Chakravorti is Senior Associate Dean of International Business & Finance at Tufts University's the Fletcher School. He's also the founding Director of the Institute for Business in the Global Context and author of The Slow Pace of Fast Change.