Is a Crisis in Developing Countries Looming, the Third Part of the ‘Crisis Trilogy’?

The American Fed left interest rates unchanged at zero percent last week due to uncertainty regarding global economic growth, while some experts go a step further and warn that a crisis in developing countries is looming, the third part of the ‘crisis trilogy’.

Since the beginning of the financial crisis in 2008, when the American central bank Fed reduced the key interest rate to a record low level close to zero percent, there has been a debate about the risks of such a move. Because, there is no longer room for further cuts.

Monetary policy relies on the application of primary instruments – raising and lowering the targeted interest rate – to stimulate economic expansion or calm the economy when there is a threat of overheating and excessive inflation. When interest rates are at zero, that instrument loses its usefulness: they cannot be cut further, so central banks are forced to use extraordinary measures, such as purchasing government bonds, so-called quantitative easing, to combat crises. Seven years later, a new risk has emerged – that zero percent has practically become an anchor for interest rates that is harder to get rid of than expected. The three largest central banks in the world – the Fed, the European Central Bank (ECB), and the Bank of Japan (BOJ) – have already lowered interest rates to zero.

 ‘The Butterfly Effect’ in the Global Economy

Although Fed officials claim that the U.S. can exit this society and raise interest rates, the latest decision to keep them at record low levels was made due to uncertainty regarding the new economy of the ‘butterfly effect’ – meaning that turmoil in Chinese markets could harm the U.S. economy. This is a situation that could cause the Fed to get stuck in its efforts to raise interest rates until the entire global economy grows in synchrony and the horizon is ‘clear’ of danger.

– It is possible that the U.S. labor market is weak and that we may not have reached the targeted inflation, but where does it say that everything in the world must align for extraordinary measures to begin to be abandoned? Those conditions will never be fully met, says Erik Weisman, chief economist at MFS Investment Management.

– Last week’s decision to postpone the interest rate hike “shows that the Fed is adopting the idea that excessive global capacities play a larger role in determining wages and prices in the U.S.,” says Steven Ricchiuto, chief economist at Mizuho Securities.

Fed Chair Janet Yellen emphasized last week that the decision to raise interest rates was postponed due to global events that have affected the U.S. economy, undermined inflation, and threatened to harm the growth of the entire global economy. For most of last year, Fed officials said they expected these factors – from low oil prices globally, to a strong dollar and a faltering Chinese economy – to fade and allow for growth in inflation and wages. However, the latest Fed forecasts show that this has not happened, so the targeted inflation of 2 percent is now expected only in 2018, despite low unemployment, or high employment in the U.S., which should encourage consumption. Yellen believes that the fundamental mechanics in the economy will eventually kick in and lead to higher inflation, but the central bank is more uncertain than ever about when that might happen.

Due to zero interest rates, other risks are also looming, including the possibility that low inflation and low interest rates could increase the likelihood of long-term deflation. This is a situation Japan has faced, which has been battling deflation and economic stagnation for decades. Given that there is no sign of rising inflation or significant economic growth, Europe is also threatened by an extended period of interest rates at zero. As is the case with the U.S., this could be a sign that global demand, global wage levels, and global growth could shape Fed policy more than its officials think. This is a situation long known to officials in developing countries, who complain that their countries are excessively exposed to what is happening in the U.S. and other major economies. As the Fed now acknowledges that events in the global economy affect the U.S., this interdependence could become a global standard in the future.

 Is the Third Part of the Crisis Trilogy Coming?

Although the Fed indicates that it could raise interest rates by the end of the year, many experts warn that this interdependence in the global economy could lead to the continuation of loose monetary policy, or keeping interest rates close to zero. Moreover, as the chief economist of the Bank of England Andy Haldane believes, the world may be plunging into a new phase of financial crisis – this time in developing countries. Developing countries are under strong pressure due to the slowdown in growth of the Chinese economy, the world’s largest consumer of raw materials. As a result, demand for raw materials is weakening, causing their prices to fall. Oil prices and many industrial commodities are at their lowest levels in years. And many developing countries do not only depend on low interest rates in global financial markets but also on economic growth in the world as many of them are major exporters of raw materials. This is why, for example, Brazil and Russia have plunged into recession.

– The latest events in Greece and China could be called the third part of the crisis trilogy, says the chief economist of the British central bank Haldane.

The first global financial crisis triggered in 2008 by the bursting of the ‘bubble’ in the U.S. real estate market was followed by a debt crisis in over-indebted eurozone members, which threatened Greece’s exit from that bloc. Although many expect an interest rate hike from the Bank of England due to stable growth in the British economy, Haldane says that interest rates in Britain could actually be reduced below the record low of 0.5 percent. Even if they start to rise, he says, they could soon fall back toward zero due to future problems. Therefore, he believes that central banks should consider new measures that have not been taken before to ensure sustainable economic growth.

– If global real interest rates remain low, central banks should be more imaginative in thinking about how to deal more permanently with the technological constraints imposed by zero interest rates. This would require a rethinking of many existing fundamental practices of central banks, concludes Haldane.