In communicating its decision not to raise interest rates last week the US Federal Reserve raised the importance of international economic and financial market developments in its reaction function. The last time the parochial authority allowed international market turbulence to halt a domestic tightening cycle was in 1997-98. Back then it was all about LTCM, the Asian financial crisis, and Russia. Now, it is all about China.
Given the delicate state of the market, Yellen is taking a softly, softly approach to weaning investors off the psychological zero interest rate policy the Fed has had in place now for almost seven years.
The delicate state of financial markets is understandable. Having been rocked by yet another tantrum in August, investors are still assessing the data for any structural damage. The focus for that assessment is principally on China. For most investors, ourselves included, the base case for China is that it is slowing, but in a stable fashion. This weaker growth profile can be more than supported by a strengthening growth profile in the US, Europe and Japan.
Since the decision by the Chinese authorities to devalue the RMB on August 11th markets have been reflecting on just how fast the pace of growth is slowing in China. Perversely, doubts about slower growth can become self-fulfilling. Questions about the pace of slowing have led to a rise in private capital leaving China; this has put downward pressure on the CNY, causing the PBOC to intervene to support the currency; by selling USD and buying CNY, this intervention creates a tightening of financial conditions; tighter financial
conditions leads to slower growth.
The PBOC has attempted to offset this tightening by cutting official interest rates (5 cuts in nine months). But even after this easing in monetary policy, financial conditions in China are still as tight as they were back in October 2008 principally because lower interest rates encourages further capital flight.
This circularity highlights an impossible Trinity – no country can have a fixed exchange rate, an open capital account, and enjoy an independent monetary policy regime at the same time. The Trinity is coming under particular strain now because as the US raises interest rates, the interest rate differential to the US narrows, making it more likely that capital outflows from China will accelerate.
The end game requires China to do something – either reverse course and re-introduce capital controls to stop the bleeding from its foreign reserves, or let the CNY adjust freely to market forces (and potentially raising fears of a currency war). Certainly more domestic stimulus measures can be expected in the near-term and this will provide some support for the economy. However, the PBOC’s ability to reduce interest rates much further appears constrained by its desire to limit FX depreciation.
This leaves much of the stimulus to come from the fiscal side. More infrastructure spending is an option but with investments at 48% of GDP it goes against the intention of the authorities to rebalance the economy towards consumption. And while federal government debt levels are low, sharply rising local government debt is a hindrance.
While we don’t believe global financial conditions are as concerning today as they were back in 1997-98, we do accept that it is prudent to be cautious. Janet Yellen is giving herself more time to assess the structural consequences of the recent volatility in the market. From a purely domestic perspective, the economic data in the US supports the case for a gradual lift-off.
The increased focus on China by the Fed makes the timing of lift-off more uncertain and means an even greater focus will be placed on (sometimes questionable) Chinese monthly economic data. Unfortunately for investors, this therefore means volatility is here to stay a little longer.