The markets have been sending out distress signals. Stock volatility has risen sharply, and bond yields have fallen below zero in part of the world while rising sky high elsewhere ” all indications of distress as Britain approaches a pivotal vote on whether to exit the European Union.
With turmoil like this, it's easy to see why the Federal Reserve would stand pat on interest rates, as it did Wednesday: safety first. With the global economy looking shaky, it must have seemed unwise to tighten the monetary policy screws further.
But the Fed faces difficult choices. A look at its own data suggests that its policies have led to financial imbalances that place it under pressure to raise rates, as it has repeatedly said it will do.
One problem is that the purchases of trillions of dollars of bonds by the Federal Reserve and other central banks in a strategy known as quantitative easing have contributed to the extraordinarily low yields in much of the bond market.
Another, less obvious problem is that by helping to engineer such low rates, the Fed has helped create a surge in US household wealth that has far outstripped growth in wages and incomes.
Low interest rates increase bond values directly, because rates (also known as yields) and bond prices move in opposite directions. Those low yields have made many other investments, from stocks to houses and other real estate, much more appealing in comparison.
This increase in wealth may have helped stimulate the economy, but because wealth has grown so much faster than wage income since the last financial crisis, measures of inequality, in both wealth and income, have worsened.
"The Fed's policies are largely responsible for creating a wealth cycle," said Joseph G Carson, director of global economic research at AllianceBernstein."It's past time that the Fed took some action."
Yet the case for holding rates steady, and not touching the Fed funds rate (the central bank's crucial short-term rate) is easy to make, and the Fed made it Wednesday.
In a statement, it warned of risks facing the still fragile domestic economy. And in a news conference, Janet Yellen, the Fed chairwoman, said that Thursday's British referendum could 'have consequences' for global markets.
She said,"It could have consequences in turn for the US economic outlook that would be a factor in deciding on the appropriate path of policy."
Polls indicate it is quite possible that British voters will decide that their country should leave the European Union. The British pound, Britain's global trade, the status of the city of London as a world financial capital ” all could be threatened, and so could the stability of the rest of the European Union.
In merely two days, Monday and Tuesday, the VIX index, a measure of expected volatility in the stock market, leapt 20 percent. Yields of bonds of troubled countries on the eurozone periphery, like Greece and Spain, rose to levels not reached in months, as investors demanded more rewards for the risks of holding them.
What's more, the yields of sovereign bonds in core countries like Germany and France plummeted as global investors sought a semblance of safety. This has produced some strange results: For the first time in history, the yield on the 10-year German bond moved into negative territory Tuesday.
What that means is difficult to comprehend. Buy a bond, and you get an investment that erodes in value. People who buy bonds that pay negative rates are essentially accepting that deal. Much of the bond market has been living in a bizarro world of negative interest rates in which the traditional relationship between lender and borrower is inverted, as I wrote in March.
Over the past few months, as global economic weakness has persisted, the zone of negative yields has expanded, from about $7 trillion worth of global bonds to more than $10 trillion, with no end in sight.
Yields on numerous sovereign notes of shorter maturities of, say, five years have been negative for some time. The list includes Switzerland, Germany, Austria, Sweden, Finland, Japan, Denmark, the Netherlands, Belgium and France. A saving grace, for investors in such bonds, is that if yields keep dropping, prices, which move in the opposite direction, will rise, and handsome profits can be made when the securities are sold.
The US Treasury is not selling bonds with negative interest rates, but yields on 10-year Treasurys have plummeted as well, dropping close to 1.5 percent on Thursday. Since 1981, such securities have yielded more than 6.3 percent, on average, a staggeringly large gap. The current ultralow Treasury yields make sense only when compared with the even lower yields available elsewhere around the world.
While the Fed influences the entire fixed-income market, it directly controls only short-term yields through the Fed funds rate, which it raised to 0.25 percent, from nearly zero, in December.
The Fed has repeatedly said it would increase that rate further, only to backpedal. On Wednesday, it did so again, forecasting that the rate would reach only 1.6 percent next year, down from a projection of 1.9 percent made in March; and only 2.4 percent in 2018, down from a March projection of 3 percent.
While wage inflation appears to be on the increase, and the unemployment rate is quite low at 4.7 percent, some recent data on the labour market and on inflation has been disappointing, gross domestic product has been growing slowly, and the Fed has decided to be extremely cautious in setting rates.
Yet from the perspective of household wealth and asset prices, the dangers of Fed inaction are readily apparent. By keeping interest rates low for so many years, the Fed has not merely reduced fixed-income yields. It has increased the value of other assets, to spectacular effect.
In the first quarter of this year, the Fed's report,"Financial Accounts of the United States," shows that total household wealth rose by $837 billion, to $88.1 trillion. That figure, which includes the value of financial assets and homes owned by US households and nonprofit corporations, increased $32.5 trillion, or 58 percent, since the end of the last recession in June 2009.
Growth of household wealth has outstripped income, enriching those lucky enough to have houses and financial investments and leaving those who rely solely on wage income far behind. Asset prices may not be high enough to call them a bubble, but they are high enough for ordinary people to exercise caution. That wasn't the case in 2009, when the Fed embarked on its loose monetary policy, deliberately encouraging people to buy riskier assets.
In Carson's view, it's past time to raise rates, both to stay ahead of inflation and rein in speculative excess.
Higher interest rates would even have a stimulative effect for a while, he says, because people with savings would benefit from higher interest payments.
Yet with the threat of disruptions abroad, and economic growth tepid at best in the United States, arguments for waiting longer prevail. Central banks are in a tough spot, dealing with economic problems for which quick remedies are not readily apparent.