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Lack of economic muscle? U.S. at mercy of China, strong dollar

Signs of slower growth, at home and abroad, confound Fed

Reuters

Vice President Joe Biden on a visit to China. He’s among many top U.S. officials paying close attention to the economy of the Asian behemoth.

(MarketWatch) — The U.S. economy used to be like a muscleman surrounded by 98-pound weaklings. It regularly flaunted its power and was little swayed by what happened to the crowd on the beach.

Those days, if they ever really existed, ended long ago. Although the U.S. is still more insular than its major economic rivals, some 30% of the nation’s economy involves trade through imports and exports. That’s a record high and about three times larger compared to several decades ago.

The result: U.S. policy on interest rates and related matters are at the tender mercy of events around the globe, and the picture isn’t pretty. That’s why the Federal Reserve last month jettisoned a pending increase in interest rates and is now likely to wait until 2016.

Three things are holding the Fed back: Softer growth in China, a strong dollar and weak U.S. inflation. They are all tied together.

Start with China. Evidence of slower growth caused stock markets worldwide to slump in August and September, freezing the Fed in place. Central bankers worry about spillover effects if the Asian giant’s slide continues.

With a light U.S. economic calendar, investors will pay close attention this week when China gives an update on third-quarter gross domestic product. The pace of annual growth is expected to dip below 7%, but if it falls under 6.5%, another global stock rout could ensue.

“There is a lot of fear about the news out of China,” said Scott Brown, chief economist of Raymond James. He thinks the worries are overblown.

Yet with China fresh on their minds, top Fed officials are worried that an increase in interest rates now could cause more harm than good. They are particularly concerned about making a move that would boost an already soaring dollar even further.

The strongest dollar in more than a decade has dealt a heavy blow to manufacturers and companies that rely on exports, making American-made goods more expensive for foreigners to buy. Amid a slump in exports, those companies have responded in turn by cutting investments, postponing new hires or even eliminating jobs.

That might help explain why hiring in the U.S. slowed sharply toward the end of the summer, giving the Fed even more reason to wait on rates.

“The Fed is stuck now.”
- Steve Blitz

A strong dollar that makes imports less expensive, combined with cheap oil, has also driven U.S. inflation to fresh lows. The downside is that it puts added pressure on American companies to reduce prices or trim costs to hold onto market share. Profits and sales are also taking a hit.

With inflation so low, it’s hard for the Fed to argue it needs to raise rates right now. Inflation over the past 12 months is zero. The central bank’s main justification is the sharp drop in unemployment, but that argument has been tested by the seeming slowdown in job creation.

“The Fed is stuck now,” said Steve Blitz, chief economist of ITG Investment Research.

Like the imaginary muscleman on the beach, the Fed is not as powerful as it once was, either. And senior Fed officials also seem as conflicted as ever about what to do.

“I wouldn’t expect it would be appropriate to raise rates” given the current state of the economy, Fed Gov. Daniel Tarullo said in a CNBC interview last week.

Yet keeping interest rates super low, though intended to boost the economy, has not proven to be quite the panacea the Fed had hoped. And by constantly putting off a rate hike, the central bank could even be undermining the confidence of businesses and consumers.

If the Fed thinks the US. economy is still too fragile to bear even a slight increase in interest rates, why would businesses or households act with any more confidence?

“When money is this cheap it’s also a signal that something is wrong,” Blitz said.