Turn the clock back a month.
It is the week before Christmas and the Federal Reserve has just raised interest rates for the first time in almost a decade.
The mood in the markets is upbeat. A so-called Santa rally is in full swing. Dealers say the US central bank has played a blinder by keeping Wall Street sweet. If there were Oscars for central bankers, Janet Yellen would be picking up the golden statuette.
Four weeks and one market meltdown later, the Fed’s decision no longer looks quite so clever. Indeed, if things continue as they have since the turn of 2016, the increase in US interest rates will go down in the annals as one of the great economic blunders.
The rationale for higher borrowing costs always looked questionable. Interest rates were pushed up not because inflation was a problem but because the Fed expected inflation to be a problem some time in the future. Sure, unemployment was coming down, but wage growth was not going up.
Yellen and her colleagues had a choice. They could act pre-emptively and raise rates while inflation was low, or they could wait until they could see the whites of inflation’s eyes. They chose the former and they chose wrong.
Almost all the data since the Fed raised rates has been weak. Plunging oil prices were supposed to encourage consumers to spend, but they are saving rather than spending the windfall. Retail sales fell in December and for 2015 as a whole were at their weakest since 2009.
Corporate profitability has been falling and up until now share prices have been artificially inflated by companies buying back their own stock. Industrial production also fell in December, partly as a consequence of the strong dollar, which is making US exports dearer and imported goods cheaper. The month-on-month fall was the steepest since 2008, but perhaps even more worryingly every other time industrial production has been this low the US has been in recession.
Other central banks have been here before. The European Central Bank raised rates in 2011 only to later reverse the decision as the eurozone economy tanked. The Swedish central bank did the same. Wall Street currently estimates that there is a 10% chance that the Fed will reverse the December rate increase later this month. The Fed has got a great dollop of egg all over its face.
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