The Fed should heed IMF’s global economic growth warnings

When the Federal Reserve Open Market Committee next meets, it would do well to pay serious attention to the International Monetary Fund’s (IMF) warnings about the downside risks to the global economic outlook. Such risks, which are all too likely to materialize, could have a material impact on the U.S. economic recovery and could push the U.S. economy toward deflation.

{mosads}The three main global risks that the IMF highlights, which are particularly relevant for the U.S. economy, are those pertaining to the Chinese economic outlook; the incipient crisis in the commodity-producing emerging market economies; and the likelihood of a further dollar appreciation, especially should the Fed start raising interest rates. These risks are all the more pertinent considering that the emerging market economies now account for around 45 percent of U.S. exports and until very recently were the main engine of world economic growth.

The IMF’s concern about downside risks to the Chinese economy would seem to be well-founded. After all, China is presently engaged in the difficult balancing exercise of moving its economy away from an unsustainable investment and export-led growth model to one that places more emphasis on consumption-led growth and the service sector.

Making that task all the more difficult is the fact that China is trying to achieve this feat at the same time it is having to deflate a massive debt bubble that built up in the aftermath of the 2008 global economic recession. In that context, it bears emphasizing that between 2008 and 2014, Chinese credit increased by around 90 percent of gross domestic product (GDP), which was around double the size of the credit bubble that preceded the U.S. housing bust that began in 2006.

The IMF’s concerns about risks emanating from the major commodity-producing emerging market economies like Brazil, Indonesia, Russia and South Africa would seem to be equally well-founded. After all, international commodity prices, including oil, have plunged to levels not seen in more than a decade, while capital is fleeing those countries at rates last seen during the Asian currency crisis in the late 1990s.

As the IMF correctly notes, these developments are all the more troubling considering that emerging market corporate debt has ballooned from around $4 trillion in 2002 to $18 trillion at present. Also of concern is the fact that these corporates have borrowed excessively in U.S. dollars, which makes them particularly vulnerable to currency movements.

The U.S. economy will have to contend with weakening economic growth from abroad at the same time that economic troubles abroad are more than likely to further strengthen the U.S. dollar. One would think that this must be of particular concern to the Federal Reserve, considering that the dollar has already appreciated by around 15 percent over the past year. Any further appreciation, coupled with depressed international commodity prices, is almost certain to keep U.S. inflation well below the Fed’s desired levels for the foreseeable future.

To be sure, Federal Reserve Chair Janet Yellen has created a credibility problem for herself by having repeatedly spoken of the high likelihood that the Fed would raise interest rates by year-end. However, before she allows such considerations to induce her to raise interest rates by year-end, she might want to consider how much more seriously her credibility would be damaged if she were soon forced to reverse such an interest rate hike decision. Sadly, that would be all too likely should the global economic risks that the IMF has been highlighting indeed materialize.

Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.