Argentina's Freak-Out Could Give Fed Pause

U.S. economic data will play the largest role in the Fed's decision-making, but Latin American instability could be a spur toward standing pat.
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Monday morning, the market, well, it went a little funny in the head. Latin American stocks tumbled and Treasury bond yields rallied by more than 10 basis points -- all because an Argentine presidential candidate appealed to the Pope for debt relief on the order of, oh,

$100 billion

. The whole thing was over by mid-Tuesday -- said candidate,

Eduardo Duhalde

, retracted his remarks; the Latin markets recovered; and others just steamed along.

But events like this certainly don't make the

Federal Reserve's

job any easier in the coming months. Last year's global liquidity crisis led the Fed to lower interest rates three times, and this week's scare emphasizes just how jittery the global markets still are. More ominously, what happened was caused by a presidential candidate who basically misspoke. What if there's a real crisis?

Strategists believe that these types of events are a secondary factor for the Fed heading into the Aug. 24 policy meeting and subsequent ones, on which the market will first get a line at Fed Chairman

Alan Greenspan's Humphrey-Hawkins

testimony next Thursday. If the Fed's unsure about which way to go come next meeting, these concerns might tip the scales in favor of standing pat. But domestic data are once again more important, so long as the global markets remain calm.

"It's been roughly a two-year

global crisis, but the only time it carried primary weight with the Fed was on the heels of the Russian devaluation," says David Jones, chief economist at

Aubrey G. Lanston

. Then, "Greenspan was worried that the global financial crisis would negatively affect our economy and our financial markets. In almost every other instance, you have to say the domestic economy was always No. 1."

What This Is All For

Before this week, another 25-basis-point rate hike in August was a pretty good bet. Inflation data remained benign, but the Fed demonstrated that it's most worried about the pace of demand and drum-tight labor markets, neither of which has receded in the past two months. Raising the

fed funds

target rate to 5% from 4.75% last month was meant to pre-empt inflation, and many economists felt the Fed would do it again in August.

But the events of this week throw a spanner in the works. The Fed cut rates three times last year, to 4.75% from 5.25%, as a response to global contagion. In its most recent

statement, the Fed said the three rate cuts were "judged no longer entirely necessary." How many of the cuts are still necessary: one or two?

John Lonski,

Moody's

senior economist, believes the Fed has to continue to weigh carefully the fragility of other global economies and what effect raising interest rates will have on still-shaky areas such as Latin America. For one, the Argentine peso is pegged to the U.S. dollar -- higher interest rates here would likely strengthen our currency, and Argentina's in turn. It would undermine that country's hopes for an economic recovery because it would increase prices on that country's exports.

A weaker currency can enhance a country's recovery because it cheapens goods for export, currently happening in Brazil. That country allowed its currency to float against the dollar, and that devaluation helped strengthen its economy in the past few months. If these foreign economies weaken again, it could cause a flare-up of investor fear, causing a pronounced flight from riskier assets into safer domestic bonds.

"What happened in the past week is a warning that somebody could just hint of a possibility of a moratorium on debt payments, and that in turn can push the equity markets lower and give

Treasury bonds a boost," says Lonski.

However, there are others who believe that the credit markets will continue to suffer from minor blips caused by external events but will bounce back because of their readiness to respond to crisis after last year's turmoil. The Russian devaluation coincided with a downturn in several Asian economies. The markets also had to contend with

Long Term Capital Management's

disclosure of its massive liquidity problems. All three put the credit markets in a deep freeze.

Now, banks and investors are taking less risk in emerging markets than they were last year. Russia can't really implode any more than it has, and the perception is that problems within global markets could be contained to specific countries or regions.

"It was an important fire drill for the market and showed it is still paying attention to external financial threats," says James Glassman, senior U.S. economist at

Chase Securities

. But "what was unique about the Russian crisis was that not even the

International Monetary Fund

could prevent this. People have gotten it in their mind that turmoil is somehow going to freeze the Fed's hand. But what got the Fed to move was a unique combination of events -- it was like the 100-year flood."

It Just Doesn't Matter

If domestic economic data mirror this week's, it may not matter anyway. The Fed's worry about demand eventually causing price inflation isn't supported by the June

consumer price index

, unchanged for the second month in a row -- the first time that's happened in 13 years -- or by the

producer price index

, which fell 0.1% in June.

In response to a question before the

Joint Economic Committee

June 17, Greenspan told members of

Congress

that he didn't see any inflation yet. The Fed raised rates anyway, concerned about tight labor markets. The June CPI and PPI reports argue for a steady policy, even if the PPI showed increases in prices of intermediate and crude goods, which at some point could be passed on to the consumer.

"I think they're happy to keep their policy unchanged, because of the good inflation news and the fact that they can afford to wait," says Jones. "With the fragility of the global recovery, it's a good reason to keep their policy unchanged."

Then again, there's a whole month to wait -- plenty of time for people to freak out.