America is the world’s largest economy, and the dollar the world’ s main reserve currency, so what the Federal Reserve - the US central bank - decides, matters. Last week, the Fed left interest rates unchanged. Its decision, however, was less influenced by benign economic conditions at home, and more by worrying developments abroad - a slowdown in China, weakness in emerging economies, collapsing commodity prices, and signs of increased volatility in global stock markets.
The Fed in managing monetary policy has a dual mandate, to achieve price stability and full employment. Inflation in the US remains negligible (0.4 per cent) and a 5.1 per cent unemployment rate means its economy is close to full employment.
A couple of months ago, a US rate rise in the autumn seemed likely. But that was before China devalued its currency, as its economy slowed, and before its stock market tumbled – falling by 40 per cent in value – despite the government’s crude efforts to prop it up. Against a background of increased economic uncertainty, and signs of weaker global growth, the Fed last week deferred a rate hike decision
Central banks prefer to be proactive rather than reactive: to anticipate events, rather than to respond to them. In the US, interest rates have never been lower for longer (for almost seven years) but delay in raising rates also carries increasing risk. Low interest rates, or cheap credit, as a form of economic stimulus, can over time result in the misallocation of capital, causing asset price bubbles that lead to higher inflation.
For now, the Fed considers that, given economic weakness in China and slowing global growth slowing, deflation is a greater threat than inflation. US interest rates, it seems, are set to remain on hold – at least until the full impact and implications of China’s economic slowdown can be more fully assessed. The Federal Reserve, in keeping interest rate unchanged, has benefited the world economy for now, while indicating it may change its mind by December.