The Fed’s New Froth Problem

From an economic standpoint, it makes sense for the Federal Reserve to hold off on rates; but then there’s what’s happening with asset prices

By Justin Lahart

The Federal Reserve was successful in getting ahead of Brexit worries, but the central bank still has to be on guard for the fallout. Photo: karen bleier/Agence France-Presse/Getty Images

The past few weeks have been very good for the Fed. Its Brexit worries proved prescient and its inaction on rates this year looks like a canny prediction of slowing growth and weaker currencies overseas. The risk is that asset prices keep soaring, potentially setting markets up for a crash when the Fed does move.

U.S. investors’ moment of post-Brexit fear has more than passed—witness the stock market’s new highs—but for the Fed it is still something to worry about. Unsure of how big a hit Britain will absorb and what sort of fallout the global economy will take, the central bank looks likely to keep rates on hold not just at its policy meeting later this month but at its September meeting as well.

One danger is that Brexit has little impact and the economy picks up steam, leading to an even tighter job market and an unexpected jolt of inflation. Given the state of the rest of the world and the probable moves in currencies and that risk seems unlikely.

The U.K. is hardly the only challenge the global economy faces in the months ahead. Europe’s already-weak economy must cope not just with Brexit but with Italy’s banking woes. A strong yen is hurting Japan’s economy, putting pressure on officials there to intervene in the currency market and launch fresh stimulus. And with their earlier stimulus efforts losing steam, Chinese officials have been allowing the yuan to weaken in an effort to bolster exports.

All of those things suggest the dollar, which shot higher after Brexit, may have more room to run, according to strategists at Evercore ISI. That would weaken America’s trade position while further restraining inflation, effectively doing a lot of the Fed’s work for it. In that context, waiting until December to raise rates would be easy.

But a stronger dollar affects the economy in different ways than Fed rate increases, which lead to higher borrowing costs, lower investment and reduced asset values. It weighs on U.S.-based manufacturers, who face increased price competition from foreign counterparts both at home and abroad, but it doesn’t directly affect more insulated businesses. And by making imports cheaper, it puts some businesses and many consumers in a better place.

Similarly, dollar strength weighs on prices for goods, which are heavily exposed to trade, but leaves prices for services, which have been rising, unscathed.

Moreover, expectations that the Fed won’t tap the brakes may only increase the attractiveness of U.S. assets for global investors. That may be one of the factors behind the rally in stocks, and part of the reason why yields on junk bonds have fallen to their lowest point against Treasurys in nearly a year.

Prices for other income-generating assets, such as commercial property, could also get bid higher.

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