Investors apparently were worried that the Federal Reserve’s unwillingness to raise interest rates signals a weakness in the global economy. The Federal Open Market Committee on Thursday became the 55th consecutive FOMC meeting in which the Fed was unwilling to risk even a modest 25 basis point (0.25 percent) increase in its key interest rate, the Federal Funds rate.
The fear on Wall Street was intensified as the market learned, as WND reported Thursday, that for the first time ever, one member of the FOMC suggested the U.S. needs to move to negative interest rates, at least until the end of 2016, to achieve full employment and hold inflation at the 2 percent target.
With negative interest rates, financial institutions would start charging customers a fee to keep money on deposit instead of paying them interest.
Investors also worried that the central banks around the world, including the Federal Reserve, may have run out of monetary tools with which to stimulate the economy. Prior to the FOMC meeting, the conventional wisdom on Wall Street was that a Federal Reserve decision to increase interest rates would cause the stock market to move sharply downward. But the Dow suffered a triple-digit loss on Friday, because the Federal Reserve failed to increase interest rates.
If the Dow continues correcting downward, it appears the Fed’s only remaining tool is to pursue the untried approach of negative interest rates.
Fed caught in ‘liquidity trap’
The widely read financial blog ZeroHedge.com worried that the Fed is now caught in a liquidity trap. The phenomenon of Keynesian economics occurs which the injections of cash into the private banking system by the central bank fails to stimulate economic growth, precisely because interest rates have been held at or near zero for so long that pumping more money into the financial system fails to stimulate the economy.
After assuming the chairmanship of the Federal Reserve Jan. 6, 2014, Janet Yellen ended the policy of Quantitative Easing in which the Fed purchased Treasury debt in an effort to stimulate the economy by keeping interest rates at or near zero.
While Yellen has successfully tapered QE down to zero, the current dilemma is whether the Fed can now “pivot” the strategy into a more normal cycle by allowing interest rates to rise above zero. Former Fed Chairman Alan Greenspan employed that tactic after 9/11, lowering interest rates to 1.25 percent by the end of 2002.
Greenspan’s return to increasing rates worked.
On Oct. 9, 2002, the Dow hit a low of 7,286.27. Then, on Oct. 15, 2002, the Dow closed above 8,000, at 8,255.68. From there, it climbed steadily for the next five years, reaching an all time high of 14,164.53, on Oct. 9, 2007, allowing Greenspan to retire as a hero.
Global economic downturn
The question plaguing Wall Street pundits now is whether a liquidity trap has placed Yellen in a position in which pivoting to higher interest rates may not work, as evidenced Friday when the Dow suffered a three-digit loss after the Fed decided not to raise rates.
“When China transitioned to a new currency regime last month, what should have been immediately apparent to everyone, was that the Fed was, from there on out, cornered,” ZeroHedge.com noted. “Boxed in. Trapped.”
The underlying reality the Fed appears unable to escape is that China’s decision Aug. 11 to devalue the yuan by 3 percent signaled to investors worldwide that the global economy could no longer depend on the “miracle of China’s economic growth.”
If the economic slowdown in China spreads to the European Union and the United States, central banks around the world, including the Federal Reserve, may face a historic stock market meltdown, regardless if rates are increased or held at zero.
With the Dow closing Friday at under 16,400, it has now lost nearly 2,000 points since it peaked at 18,312.39 on May 19.