Federal Reserve System: After 'Black Monday' Meltdown, Will The FOMC Still Raise Interest Rates In 2015?

Even before China’s stock market began to tumble this week, the U.S. Federal Reserve was questioning its stance on an interest-rate increase planned for sometime later this year. Many experts had forecast September as the most likely time frame for the central bank to lift rates for the first time in nearly a decade.

But over the past week, the economic landscape has shifted.

Global markets reacted violently this week on signs that China, the world’s second-largest economy, is decelerating at a much faster pace than expected. The Dow Jones Industrial Average plummeted more than 1,000 points in the first four minutes of trading on Monday, and by the close, the blue-chip index was down 588 points.

In recent months, as China showed signs of causing a global economic slowdown and Greece threatened to exit the eurozone, a growing number of economists and policy experts have expressed concern about the timing of the Fed's next rate increase. Amid the financial market volatility of the past week, the critical voices have grown louder.

“September is off the table, and December is anyone’s guess now,” said Tony Roth, chief investment officer at Wilmington Trust. Roth said the Fed would be “out of touch” with market events if it were to raise rates next month.

Too Soon?

Former U.S. Treasury Secretary Larry Summers took that sentiment even further in an op-ed in the Financial Times on Monday. Summers even invoked the c-word -- crisis -- in his argument that it would be a mistake for the Fed to raise interest rates this year. He said a move would threaten the central bank's major objectives: price stability, full employment and financial stability.

"At this moment of fragility, raising rates risks tipping some part of the financial system into crisis, with unpredictable and dangerous results," Summers wrote. Later he took to Twitter, urging the Fed to reconsider raising interest rates this year in the aftermath of Monday's sell-off.

Experts continue to question whether the U.S. economy is strong enough to move away from crisis-level rates, which have hovered at historic lows since the Great Recession.

“The question is whether investors are going to be excited about the Fed holding off on raising rates, or start to get concerned the Fed can’t raise rates by just 25 basis points after seven years,” said Charlie Bilello, director of research at Pension Partners.

Bilello explained that if the Fed doesn’t raise rates next month, it will confirm some suspicions that when it says its “data dependent” it really means the Fed cares more about the level of the S&P 500. If the index drops enough, they won’t hike rates, Bilello said, which is what happened in 2010 and 2011 when the S&P 500 declined 17 and 21 percent, respectively.

The index hasn't dropped more than 10 percent since 2011.

“That’s the template experts are working off of. Since the decline was more than 10 percent Monday, it should be enough to stop them from hiking rates this year,” Bilello said. Before U.S. markets opened Tuesday, the index is now down 11 percent from its most recent high on May 21.

The Fed was supposed to hike rates at the end of 2010, or the end of 2011, according to the Fed funds futures. Not only did the Fed come out saying it would not lift rates, the central bank also initiated new rounds of stimulus, dubbed “quantitative easing” in 2010, followed by “Operation Twist” in 2012, in an attempt to lower long-term interest rates. The Fed stepped in again that year with a third round of stimulus, referred to as “QE3.”

Today Vs. The 1990s

To be sure, the U.S. economy has a history of flourishing while withstanding slowdowns across the globe. In 1997, for instance, the U.S. boomed and avoided a financial contagion while much of Asia endured an economic meltdown.

But the U.S. is in a different place today. In the late 1990s, the economy benefited from a combination of ideal conditions: low unemployment, peaking productivity from baby boomers, a debt cycle that had not yet peaked, and a technology boom.

The Fed's current narrative is that its five-year asset-purchasing program helped the U.S. avoid further economic catastrophe in the aftermath of the 2008 financial crisis. But as the third phase of the Fed’s effort, or “QE3,” came to an end last October, and as the central bank debates whether to raise rates this year, many economists fear the U.S. economy hasn’t yet returned to full strength and may not be able to withstand a China-induced global slowdown. The Fed is putting a Band-Aid on the wounds from the Great Recession, but the wounds still haven’t healed, notes Adam Sarhan, founder and chief executive officer of Sarhan Capital.

“If you look at Wall Street, it reacted perfectly to the Fed’s easy money policy. It’s followed the central bank’s script perfectly,” Sarhan said. “But if you look at Main Street, it hasn’t.”

Up Next, Jackson Hole

Economists are looking ahead to the annual Economic Policy Symposium in Jackson Hole, Wyoming, this week, which brings together many of the world's central bankers. Stanley Fischer, the Federal Reserve’s vice chairman, is scheduled to give a speech that could provide further clues about the Fed's next move.

Federal Reserve Bank of Atlanta President Dennis Lockhart said Monday he continues to expect a rate hike this year, but cautioned that a stronger dollar, a weaker Chinese yuan and falling oil prices could complicate the central bank’s outlook going forward.

“I expect the normalization of monetary policy -- that is, interest rates -- to begin sometime this year,” Lockhart said Monday at a Public Pension Funding Forum in Berkeley, California. “Currently, developments such as the appreciation of the dollar, the devaluation of the Chinese currency, and the further decline of oil prices are complicating factors in predicting the pace of growth.”

Jessica Menton is a writer who covers business and the financial markets. News tips? Email me here. Follow me on Twitter @JessicaMenton.