Slowing global economy and panicky investors could lead Fed to delay a rate increase

Economic Indicators Associated Press

Just as the U.S. job market has finally strengthened, the Federal Reserve now confronts a new worry: A sputtering global economy that's spooked investors across the world.

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The economic slump could spill into the United States, potentially weakening job growth and keeping inflation well below the Fed's target rate. Such fear has led some analysts to suggest that the Fed might wait until deep into next year to start raising interest rates — and then raise them more gradually than expected.

Yet so far, the prospect of continued lower rates — which make loans cheaper and can fuel stock gains — is being outweighed by investors' mounting fears of weakness from Asia to Europe to Latin America. After shedding 223 points Monday, the Dow Jones industrial average is now 5.5 percent below its September peak. Americans with stocks in their retirement accounts have taken a beating — at least for now.

On Tuesday, solid earnings from several large U.S. banks gave stocks a boost. The Dow was up nearly 100 points, or 0.4 percent, in midafternoon trading.

Since the Great Recession ended five years ago, Fed officials have often stressed that their policies were devised to nurture the U.S. economy and job market alone. But Fed officials are now assuring international financial leaders that they will closely monitor the effects of the Fed's policies on overseas economies.

And the Fed's vice chair has publicly acknowledged that the turmoil abroad could lead the Fed to act more cautiously.

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"If foreign growth is weaker than anticipated, the consequences for the U.S. economy could lead the Fed to (raise rates) more slowly than otherwise," Vice Chair Stanley Fischer said in a speech last weekend.

Fischer's remarks followed a rash of data last week that pointed to slower growth worldwide. Germany reported sharp declines in factory output and exports, which raised fears that Europe's biggest and strongest economic power could fall into recession. China's efforts to rein in government and private debt have slowed its expansion. And consumers in Japan are still spending listlessly after a big sales tax increase took effect in April.

"The world economy's engines have been sputtering," said Douglas Porter, chief economist at BMO Financial Group.

Against the backdrop of a limping global economy, the United States looks like a comparative standout, even though the U.S. economy hasn't yet regained full health. That widening gap has boosted the value of the dollar. Compared with a basket of other currencies, the dollar has risen 7.5 percent in the past three months, TD Economics estimates.

A stronger dollar makes American goods more expensive in foreign markets and can reduce U.S. exports. It also makes imports cheaper for Americans and puts downward pressure on U.S. inflation.

Michael Hanson, an economist at Bank of America Merrill Lynch, estimates that a 10 percent increase in the dollar's value over a year would reduce the U.S. inflation rate by 0.25 percentage point. The Fed's preferred inflation gauge is already a half-point below its 2 percent target, and an additional drop could give the Fed another reason to delay a rate increase.

A further decline in inflation "would likely stop Fed discussion of a mid-2015 liftoff (in interest rates) in its tracks," Hanson said in a note to clients.

Hanson and some economists still predict that the Fed will start raising its benchmark short-term rate in mid-2015 as the U.S. economy picks up. But most say the Fed seems more likely to push its timetable further into the future than to move it forward.

The timing of the Fed's first move will affect businesses, investors and households. An increase in the Fed's benchmark rate would likely raise borrowing costs for student loans, mortgages, auto and business loans and credit cards.

Yet even if the Fed starts raising rates by the middle of next year, the global slowdown could mean it will further raise them only very slowly. Hanson thinks the Fed's benchmark rate, which has been at nearly zero for six years, will be between just 0.75 and 1 percent at the end of next year.

Even so, the prospect of lower interest rates for longer has yet to restore most of the financial markets' recent losses. That may be because the prospect of a delayed rate increase is seen as a sign of economic weakness and is concerning investors, says Dana Saporta, an economist at Credit Suisse.

And the damage to corporate profits from a global slowdown could outweigh any benefits from lower interest rates.

Hanson notes that exports make up just 13 percent of the U.S. gross domestic product. That suggests that the effect on U.S. growth might be limited to just one-tenth of 1 percentage point a year.

But roughly half the profits earned by companies in the Standard & Poor's index of 500 largest U.S. companies come from overseas.

"The dominant effect of this is going to be a less favorable outlook for profits for U.S. multinationals," Hanson said.

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Follow Chris Rugaber on Twitter at http://Twitter.com/ChrisRugaber .