Market turmoil threatens Fed's rate-hike plans

By Jason Lange and Jonathan Spicer

WASHINGTON/NEW YORK (Reuters) - Turmoil in world financial markets and growing fears of a China-led global economic slowdown threaten to derail the Federal Reserve's plans to soon start raising interest rates from near zero, dimming the chances of a September lift-off.

A near 9-percent dive in Chinese shares on Monday triggered sharp sell-offs in Asia and Europe, wild swings and losses on Wall Street, and knocked crude prices to new multi-year lows.

The rout, which follows weeks of jitters over the extent of China's economic troubles and their effect on the rest of the world, convinced investors that the Fed would hold off with action until some semblance of calm returns.

"You would be insane to raise interest rates when markets are in such turmoil," said Martin Barnes, chief economist at BCA Research in Montreal.

Compared to last week, investors now see a much lower chance the Fed will hike at its Sept. 16-17 meeting. Prices for swaps on Wall Street implied traders saw a 24 percent probability for a September move, down from 46 percent a week earlier, according to Tullett Prebon data.

The market selloff and jump in the dollar appear to have given pause to at least one Fed policymaker. Atlanta Fed President Dennis Lockhart, who two weeks ago was "very disposed" to begin policy tightening in September, on Monday said only that it was likely to occur "sometime this year."

Barclays now expects the rate hike will not come until March, after having previously pointed to September.

And BlackRock Inc's chief investment officer for fixed income, Rick Rieder, told Reuters that even though he hoped the Fed would move next month, market volatility was making it difficult.

Investors have scaled back their own bets on long-term U.S. inflation. The market gauge of those expectations - the yield spread between 10-year Treasuries and 10-year Treasury Inflation Protected Securities - hit a seven-month low on Monday, suggesting investors see inflation of around 1.5 percent over the next decade, well below the Fed's 2 percent target.

Until quite recently, the Fed had expressed limited concern over China's market turbulence, with policy debate focusing on the improving U.S. labor market and solid economic activity - and whether it should raise rates next month or in December, and at what pace it should proceed thereafter.

NEED FOR CAUTION

With market jitters hitting home, however, the U.S. central bank has a number of reasons to be cautions even about taking that first step.

One is that financial markets, with investors shying away from risk and pushing U.S. Treasury yields lower, are more prone to a nervous reaction if the Fed were to move next month.

Secondly, the Fed has to consider that market gloom might be a sign that the global economy is in worse shape than it has assumed, and the drag on the U.S. economy could be bigger than it previously predicted.

Fed policymakers have also said they want to be confident that inflation will start climbing toward target before embarking on a tightening cycle, and that goal now looks even more elusive. As a result of global demand worries oil prices tumbled by more than 5 percent to new 6-1/2 lows .

Weakness in China, the world's second-biggest economy, and softer global demand for anything from raw materials to electronic components and heavy machinery is also bad news for factories in the United States, the largest economy.

Even though China accounts for only a small share of U.S. exports, several Fed policymakers noted last month that "a material slowdown in Chinese economic activity could pose risks to the U.S. economic outlook," according to the minutes of their July 28-29 policy meeting.

Troubles abroad, such as euro zone's debt crisis, have repeatedly stunted U.S. recovery from the 2007-2009 recession, but policymakers of late have been more confident the U.S. economy can stand on its own.

The Fed has carefully crafted a message this year that the time was approaching for it to raise interest rates and a September hike is not entirely off the table. The U.S. stock market rout that began Friday could still reverse itself, and a key employment report for August might show further improvement in the labor market.

"It's only August, and markets move quickly," said Michael Feroli, chief U.S. economist at JPMorgan Chase. But he added: "The moves we've seen in markets, if they are sustained, don't help the case for September."

(Additional reporting by Ann Saphir in Berkeley, California, Richard Leong in New York and Krista Hughes in Washington; Editing by Tomasz Janowski)

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