There’s an uncanny parallel between foreign policy and monetary policy: The United States creates a mess, and then complains about instability elsewhere in the world. America’s misguided effort to bring democracy to Iraq with the election of Nouri al-Maiki in 2007, and its subsequent effort to restore the power balance with Iraq’s Sunnis during the 2008-2009 “Surge,” set the stage for protracted sectarian war. The Federal Reserve’s threat to tighten monetary policy into a weakening world economy created massive market disruptions, in the form of a soaring dollar and collapsing commodity prices. The Federal Reserve then complained at its Sept. 17 meeting that world market instability makes it hard to raise US interest rates.
Fortunately, the rest of the world is learning to work around the bloodymindedness in Washington.
It makes no sense to speak of slowing Chinese growth as a source of instability and weakness in the world economy: Chinese growth is slowing because its exports are slowing, despite a buoyant increase in domestic demand. Retail sales in China have risen 10.5% in real terms during 2015 to date, and that (as the Economist pointed out in last week’s leader) may be an underestimate due to undercounting of services. China’s growth may slow from slightly above 7% to 6% or even 5%, but China is not the source of weakness. It has succeeded in shifting its economy away from export dependency to domestic demand, but it still is vulnerable to a turnaround from 20%-30% annual export growth during the pre-crisis years to a 5% decline in dollar export volume during the past 12 months.
On the contrary: China is importing deflation by the United States through the RMB peg to the US dollar. As the expected fed funds rate rose and took the dollar with it, China was forced to intervene in foreign currency markets to maintain the dollar peg, spending $440 billion over the past year and $90 billion August alone. When China sells dollars to buy RMB, it reduces liquidity in domestic markets, and the effect of foreign exchange intervention has effectively neutralized the central banks’ easing over the past year. All emerging market currencies fell as the expected US overnight interest rate 12 months’ hence rose (gauged by the federal funds’ futures market). China had to tighten monetary policy de facto to prevent the RMB from falling.
China should have listened to Dr. Guonan Ma, formerly chief China economist at the Bank for International Settlements, who has been arguing for more than a year that China should “ditch the remnenbi-dollar peg.” As Dr. Ma wrote last February, “Over the past decade, the renminbi has gained 50 per cent on a broad real effective basis. Even allowing for fast Chinese productivity growth, there are now questions about whether the renminbi is fairly valued or even overvalued. Simply put, the once broad-based market consensus of an undervalued renminbi is gone.” If China held on to the dollar peg, Dr. Ma warned, “the result will be a deflationary blow to the Chinese economy in an environment of persistent dollar strength.” That is just what occurred.
When the Federal Reserve cites China’s weakness as an explanation for its hesitancy to raise rates, we encounter a positive feedback loop: the Fed talks rates up, the dollar rises, commodity prices crash, world export volume shrinks, the world economy slows (including China), and market volatility spikes. Surveying the mess it created, the Federal Reserve concludes that the price of tea in China is a critical variable for its economic model. Despite the Fed’s weird reasoning, the market is beginning to believe that the Fed will step away from the precipice. Just as important, it believes that the ECB will increase the pace of quantitative easing, and that the Peoples Bank of China may join in the effort.
When the FOMC put off raising rates at its Sept. 17 because of instability in global markets—instability the Fed itself had created—it conjured up the worst of all possible worlds, where the Fed acknowledged that world markets were a mess but was determined to damn the torpedoes and raise rates anyway. After a brutal week on world markets, Dr. Yellen’s discourse was greeted by skepticism.
European stocks came roaring back last Friday. A faster pace of quantitative easing by the ECB (see below) will give a new tailwind to European markets. Hardier investors with a longer time horizon might consider bottom-fishing in Brazil, India and Russia as well. It seems likely that the major central banks of the world, led by Europe and followed by China and (eventually) the Federal Reserve will respond to the risk of global economic contraction by beginning a fresh round of easing later this year.
Next month’s IMF-World Bank meetings are likely set a different tone for markets, as central bankers weigh in against the risks of deflation, and look for buying opportunities in the advent.
“Normalization” is the second most misleading idea in the current economic debate, after the notion that China is responsible for the world’s economic problems.
There is nothing normal about the US economy or for that matter the world economy. The dollar volume of world trade is down more than 12% year-on-year as of July. As we have pointed out previously, the US economy remains 10% smaller than the 2001-2008 trend would indicate, the first time the postwar period that a recovery failed to regain the previous trend line. To a hammer, everything looks like a nail, and to investors, everything looks like a levered carry trade. The Fed’s threat to raise the cost of carry caused the last six months’ instability in world capital markets, and investors do not believe that the Fed will follow through on its threats. A growing body of sophisticated opinion (e.g., Bridgewater Capital’s Ray Dalio and former Harvard President Lawrence Summers) believes that the Fed will undertake a new round of quantitative easing rather than tighten.
Ultimately Fed probably will not raise rates. On the contrary, the European Central Bank and the Peoples Bank of China will ease, and the Fed may reluctantly announce that global economic conditions have changed and follow suit. It is too early to speculate on a coordinate easing by the world’s central banks, although that is surely a possibility. A key juncture will be the World Bank-IMF Annual Meetings in Lima October 9-11, where the IMF’s Managing Director, Christine Lagarde, will lecture the Federal Reserve on the risks of premature tightening. The IMF warned in its May 28 consultation with the US:
The FOMC should remain data dependent and defer its first increase in policy rates until there are greater signs of wage or price inflation than are currently evident. Based on the mission’s macroeconomic forecast, and barring upside surprises to growth and inflation, this would put lift-off into the first half of 2016.
There is widespread expectation in the markets that the ECB will increase its quantitative easing from the present level of Euro 60 billion per month. This is reflected in the fall in the 1-month Euribor rate 12 months ahead implied by the future market from 60 basis points in July to 30 basis points today. We think the futures market has it right. The ECB is less bedeviled by Keynesian dogma than the Fed; rather than restrict its attention to the simplified one-period, closed economy model used by the Fed, it has to take global trends into account.
Europe lives on exports more than does the United States, and the ECB cannot ignore the most important single data point in the world economy today: World trade is shrinking, and has fallen by more than 12% year-on-year in dollar volume.
Only a small part of the decline can be attributed to the fall in oil and commodity prices. Most of it is due to the rising value of the dollar, which diminishes the nominal value of nondollar exports. That puts stress on dollar debtors, especially emerging markets. The International Monetary Fund’s Managing Director, Christine Lagarde, has been warning about the impact of rising US interest rates on emerging markets since March, and the collapse of emerging market currencies and equity markets since then bears out her warning. We have been warning that emerging markets are the weak link in the global economic chain throughout, most emphatically in our July 21 note (“Want Something to Worry About? Brazil’s Foreign Debt is Shakier than in 2008”).
The rising dollar is the problem, and the dollar has been driven by expectations of Fed tightening. As we see in the chart below, there is an 85% r2 between the expected fed funds rate 12 months ahead (from fed funds futures) and the trade-weighted dollar index DXY. It is also clear that the expected rise in the fed funds rate led the dollar index upward, especially as it soared between April 2014 and February 2015.
The crash in the oil price also tracks the expected federal funds rate 12 months ahead.
The world’s economic weakness, that is, is first of all a result of the Fed’s blunders. The deflationary impact of the rising dollar and falling commodity prices suppresses global demand and undermines the most levered part of the world economy, namely emerging markets. All exporting nations are suffering as a result. China is no exception, but that is the Fed’s fault more than anyone else’s.
Fed Chair Janet Yellen’s Sept. 25 speech at the University of Massachusetts encouraged the markets to believe that the Fed will not march in a straight line off a cliff. The punch line came at the end of her address:
I expect that inflation will return to 2 percent over the next few years as the temporary factors that are currently weighing on inflation wane, provided that economic growth continues to be strong enough to complete the return to maximum employment and long-run inflation expectations remain well anchored. Most FOMC participants, including myself, currently anticipate that achieving these conditions will likely entail an initial increase in the federal funds rate later this year, followed by a gradual pace of tightening thereafter. But if the economy surprises us, our judgments about appropriate monetary policy will change.
In plain English, the Fed’s model calls for a return to 2% inflation in the midst of rampant deflation, but if the model turns out to be wrong, the Fed won’t raise rates. Given that the Fed’s favorite gauge of long-term inflation expectations (the so-called 5-year breakeven inflation rate five years forward) is trading at an all time low, it is reasonable to believe that the Fed will declare a “surprise” and do nothing. (The breakeven inflation rate is the difference between the yield on ordinary coupon Treasuries and inflation-indexed Treasuries, or the inflation rate at which an investor would earn the same return on either instrument).
It’s too much too hope that the Fed will learn anything from its mishaps of the past year–just as it’s too much to hope that the US foreign policy establishment will learn from the failure of its attempt at social engineering in the Middle East. But it’s reasonable to hope that other central banks can limit the impact of the Fed’s errors.