Euro crisis puts a U.S. interest rate increase in the deep freeze

05/17/2010 9:52 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Thanks to the euro debt crisis the Federal Reserve and the Chinese government are both likely to put tightening on hold.

The Federal Reserve, which had been shrinking its balance sheet in preparation for an increase in its short-term interest rate target, now at 0% to 0.25%, at the end of 2010, added $10 billion to its balance sheet in the week that ended May 12. The additional Fed lending came as the central bank supplied more dollars to the market to meet roaring demand for dollar-denominated investments as an alternative to the tumbling euro.

The Fed’s move also reflects an increased wariness at the U.S. central bank about doing anything that would slow the U.S. recovery when it looks like global economic growth will be constrained by the euro crisis. Economists now project that Euro Zone economies will grow by just 1.05% in 2010 and by just 1.45% in 2011. Slower growth in Europe is likely to mean slower growth in U.S. exports and the last thing the Federal Reserve wants to do is raise interest rates and tighten the money supply at the same time as the euro crisis is slowing U.S. exports, and thus tip the U.S. economy back into recession.

Bloomberg’s regular poll of economists showed that as of May 10 the median forecast now calls for a very modest 0.25 percentage point increase in interest rates to 0.5% by the end of 2010. That’s down from the April 29 median forecast of a 0.75% target rate by yearend.

Speculation is increasing that the Beijing government and the People’s Bank of China are thinking the same way.

Although China’s stock market is still selling off on worries that the government will continue measures to slow speculation and control inflation, a small tide of market sentiment is starting to flow in the opposite direction.

The thinking is that China will hold off on any further big steps, such as ending the dollar peg and allowing the renminbi to appreciate, as long as turmoil in Europe threatens China’s exports to that market. Beijing is very concerned about the possibility of overshooting and taking a bigger bite out of domestic growth than the absolute minimum necessary to control inflation. With some of the surge in property prices in recent weeks possibly attributable to developers rushing to beat future restrictions on capital, the government was likely to take a breather in its tightening moves anyway to see their full effect. That inclination to caution increases with every sign that the $1 trillion rescue package hasn’t put an end to the euro crisis.

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