Greek Crisis Throwing Shade on September Rate Hike

The economic engine is purring in the U.S. but the wheels are falling off in Greece – and that might be enough to convince the Federal Reserve to delay raising interest rates beyond their September meeting.

In fact, Greece is just one of a handful of global financial turmoils that could prompt reluctance on the part of the U.S. central bank to start raising borrowing costs for consumers and governments for the first time in nearly a decade.

“China, Greece and Puerto Rico all are issues for the Fed. They reflect a global economy which is not correcting the imbalance between supply and demand,” said Steven Ricchiuto, chief economist at Mizuho Securities.

“These problems tend not to surface when the global economy is accelerating, when inflation is rising and wages accelerating,” he added. “So they are reflective of the macro environment that suggest the Fed should not hike rates in September.”

U.S. stock markets plunged Monday with the Dow Jones Industrial average down 200 points at 11 a.m. EST as Greece’s banking system descended into chaos. The government shut down banks over the weekend to prevent more panic-stricken withdrawals and it seemed almost certain Greece would default on a 1.8 billion euro payment due Tuesday to the International Monetary Fund.

What’s Next After a Default

Greece’s new far-left government has broken off negotiations with Eurozone fiscal leaders, rejecting austerity as the path forward for the debt-riddled nation. Instead, Greek Prime Minister Alexis Tsipras has called for a referendum next weekend during which Greek voters can decide whether to accept the conditions for another bailout set by European fiscal leaders.

“The dramatic end of talks on Saturday along with the vote in the Greek parliament to hold a referendum next Sunday on the bailout package proposed by the IMF, the ECB and its European neighbors, suggests that the bomb of Greek default is perilously close to detonating,” said David Kelly, chief global strategist at JPMorgan Funds.

Now the two questions everyone is asking are: will a default by Greece lead to Greece’s exit from the Eurozone; and will a default lead to a contagion that drags down financial institutions and countries holding large amounts of Greek debt.

Kelly said the situation in Greece will be dire if no agreement is reached that will allow banks to reopen and credit to start flowing again. Business will go bankrupt, he said, and unemployment will soar even higher than the current 25% estimate.

But the contagion isn’t likely to spread outside of Greece to other European nations such as Portugal, Spain and Ireland which were also threatened recently by massive debts. The “economic, fiscal and financial conditions in Portugal, Spain and Ireland are clearly improving,” Kelly said.  “In other words, the other dominos have now moved far enough away from Greece to leave them less vulnerable.”

Poor Timing

While the Greek drama was attracting most of the attention from investors, world leaders and headline writers, a similar scenario was unfolding in Puerto Rico, another relatively small economy that has been plunged into chaos by debts it can’t afford to pay. Meanwhile, China’s stock market is plunging despite efforts by that country’s central bank to spark economic activity via a rate cut.

The timing of all this international turmoil is poor for U.S. central bankers eager to ‘normalize’ U.S. monetary policy after years of unprecedented stimulus in the wake of the 2008 financial crisis.

Even cautious doves on the policy-setting Federal Open Markets Committee – an influential group that includes Fed Chair Janet Yellen and Vice Chair Stanley Fischer -- seemed determined to start nudging rates higher sooner rather than later.

U.S. labor markets have tightened considerably in the past 12 months, reducing the so-called slack that had kept wages stagnant and inflation well-below the Fed’s 2% target rate. In May wages rose 2.3% year-over-year, a significant move in the right direction. Higher wages will eventually push inflation higher, just as the Fed has predicted, a situation that justified higher borrowing costs.

But all of the market uncertainty prompted by the latest Greek crisis clearly has markets on edge, and the Fed will be understandably cautious about throwing more uncertainty into a fragile marketplace by raising rates in September.