Trump Take Note: U.S. Monetary Policy Increasingly Made in Chinaby
Fed delayed rate hikes partly in response to Chinese actions
U.S. monetary policy influenced by financial conditions
Here’s something else for Donald Trump to fulminate about. U.S. monetary policy is increasingly being made in China, not in the good old U.S. of A.
That’s an exaggeration, of course, but it’s more than just misleading click bait. It’s indicative of a broader reality that Federal Reserve policy makers more and more recognize. No central bank – even the world’s most powerful – is an island. With increasingly interconnected global financial markets, what happens overseas often quickly redounds on the U.S., and vice versa.
Here’s the reasoning behind the “Made in China” observation, as laid out by Joachim Fels, global economic adviser for Pacific Investment Management Co. , which oversees $1.43 trillion in assets.
First, hearken back to the middle of last year when Fed Chair Janet Yellen and her colleagues seemed to have teed up an interest rate increase for September. Then, bam, China engineered a tiny devaluation of its currency in August and financial markets worldwide went into a tizzy.
The Fed, worried about the impact of the turmoil on the U.S. economy, backed off, with Yellen telling reporters afterwards that a lot of the focus at the September meeting was on the “risks around China.” The U.S. central bank finally went ahead and raised rates in December after holding them near zero for seven years.
Fast forward to this year. Yellen and her team looked to have lined up a second rate hike for March after penciling in four quarter percentage point increases for 2016. China then allowed the yuan to fall in January. Markets again took fright.
Yellen subsequently singled out uncertainty about China’s intentions as she suggested in February the U.S. central bank might delay raising rates. And now investors are betting that the Fed will stand pat at its March 15-16 meeting.
Fed policy makers say monetary policy is data dependent. Yet it’s clear it’s also financial-conditions dependent, according to Fels. So if developments in China disrupt markets and cause U.S. conditions to tighten – whether it be through lower equity prices, higher corporate bond yields or a stronger dollar – Yellen & Co. will take that into account in setting policy because of its potential impact on the economy.
“The Fed is watching financial conditions very closely,” the Pimco adviser said. “And those conditions are influenced very strongly by what’s going on in the rest of the world and by what China is doing.”
China devalued its currency in August after watching the yuan rise in lock-step with the dollar as the U.S. currency appreciated in anticipation of higher interest rates from the Fed. Beijing then untethered the yuan from the dollar in December, instead tying it to a basket of currencies. In spite of that move, it’s still very much exposed to shifts in U.S. monetary policy and the impact that Fed actions can have on capital flows in and, more importantly, out of the country.
If this were just about China, it might not be all that big a deal for the U.S., as Fed Vice Chairman Stanley Fischer has observed. After all, U.S. exports to the world’s second largest economy are less than one percent of gross domestic product.
But as the biggest consumer of a host of commodities, China’s economic slowdown has an out-sized impact on the rest of the world -- and one that International Monetary Fund Managing Director Christine Lagarde confessed last September had been larger than expected. It’s also one that Fed Governor Lael Brainard said Monday the U.S. central bank needed to take account of in setting policy.
The dollar’s role as the world’s reserve currency is adding to the strains. A stronger greenback is squeezing companies in China and other emerging markets whose earnings are in their local currency and whose debts are in dollars. That’s no small beer. All told, emerging-market residents have borrowed some $3.3 trillion in the U.S. currency, according to researchers at the Bank for International Settlements in Basel, Switzerland.
The greenback’s rise also has allowed oil producers such as Russia to keep pumping crude -- in spite of falling prices in dollar terms -- because they’re still making good money in their local currencies. That in turn has implications for the U.S. stock market, where prices have recently been unusually affected by the ups and downs in oil.
At a rare joint conference with the New York Fed, People’s Bank of China Deputy Governor Chen Yulu warned on Feb. 29 that a strengthening dollar could fuel a crisis in emerging markets. He said the central banks of the world’s top two economies should work more closely to counter a trend of weakening global economic policy coordination.
So what does that mean for the Fed? As recent experience shows, it’s going to be hard for Yellen and her colleagues to completely decouple U.S. monetary policy from the rest of the world. Or, in the words of pop artist Neil Sedaka: “Breaking up is hard to do.”