Will the Fed Raise Interest Rates? Albert 'Pete' Kyle

SMITH BRAIN TRUST — Albert “Pete” Kyle is the Charles E. Smith Chair Professor of Finance at the Robert H. Smith School of Business, and a senior fellow at the Center for Financial Policy.

Q: What is the likelihood that the Fed will raise rates in September? If it does raise rates, by how much will it do so?

A: Although the Fed has been preparing the market for a rate increase, I think that it is likely the increase will not happen.  If it does happen, it is likely to be a very tiny, economically meaningless increment.

(Fed chairwoman) Janet Yellen's main goal is to decrease the unemployment rate and increase labor force participation.  She does not want to stimulate bubbles in either stock market prices or bond spreads. Talking about increasing interest rates, as opposed to actually doing it, is likely to dampen asset prices slightly while not dampening employment growth.

The main constraint on keeping interest rates low is inflation. If inflation starts to exceed a 2 percent to 3 percent annual rate for a significant period of time, then it might be time to increase interest rates. Right now, inflation is tame.

The U.S. dollar has appreciated greatly against almost all world currencies. China's devaluation last week isolates the dollar even more as a strong currency. The strong dollar keeps inflation low and thus provides cover for keeping rates low. China's devaluation will make Chinese imports into the U.S. cheaper and harm U.S. firms that compete against Chinese imports. By weakening the dollar, keeping rates low will tend to will help U.S. exporters.

Secular trends also favor keeping rates low. The fracking boom has lowered oil and natural gas prices, and this helps keep inflation low. There continues to be a worldwide savings glut, as aging workers save for retirement. These trends favor keeping rates low.

Kyle made those comments before the stock-market correction that began on Friday. On Monday, he added the following:

Today's plunging stock markets make it even less likely that the Fed will raise interest rates. The Fed's justification for probably not raising rates will likely be to promote stable economic growth in a benign inflationary environment, not to stabilize the stock market, which they are obviously watching closely.

Since the falling stock market threatens economic growth by reducing demand via a wealth effect, while falling Chinese currency and falling oil prices both tend to keep inflation benign, these economic developments provide even more justification for keeping interest rates low well into next year.

While both the U.S. and European countries are likely to keep their interest rates low, watch for some real contagion related to emerging markets debt.  As weakness in China spills over into the debt markets for Brazil, Turkey, South Africa, Russia, India, and other countries, there will be increased speculation concerning which emerging market economy will default next.  Emerging markets will be moving towards high inflation while the U.S., Europe, and Japan continue to fight deflationary forces.