Frequent readers are already aware of the cautious tone of my commentaries on the US and world economies, and specifically that I can’t quite get my arms around why the US Federal Reserve (Fed) should hike interest rates now. I haven’t said so plainly, but today I’m going to: if it was up to me (which of course it is not, thankfully), I would frankly be afraid to hike rates. This is no great revelation in itself given the recent market behavior, especially now that several eminent practitioners have made similar comments already this week. Regardless, here is my view:
Raising policy rates in a modern fiat-currency economy serves only one purpose: to reduce inflation pressure; and this effect comes at the expense of job creation and economic growth. It’s impossible to know the price tag ex ante, but it’s highly unlikely that higher policy rates are anything other than economically suppressive. Some high profile economists have made a compelling case for “financial stability,” i.e. bubble prevention, as a justification for higher policy rates, but the fact that asset prices in the US stopped going up months ago has silenced that line of reasoning for now.
Policymakers would look at inflation pressure and fragility within the job market and economic growth to assess the benefits and costs of higher policy rates. Ten months ago in A Confluence of Factors, and six months ago in A Slight Disagreement and Dogma vs Dove Soup, we discussed in some detail the anti-inflationary pressures originating outside of the US, but which make their way to the US through foreign central banks debasing their currencies versus the dollar, and through falling commodity import prices. More recently, I have focused on structural headwinds to potential growth in the US over the medium term (see: Oh Great Now This, Everything you always wanted to know about the LFPR…, and It’s Really No Secret). It may not have been apparent in stringing together these short commentaries, but for the past year, I have developed the view that the benefits of hiking rates were significantly outweighed by the potential costs.
In recent weeks, this gap has intensified even further. Most importantly, the devaluation of the yuan and reactive moves by other central banks has widened the potential monetary policy divergence between the US and the world, assuming the Fed sticks to its guns. The dollar weakness versus the euro this week, as the market priced incremental difficulty for the Fed to press ahead in September, elicited verbal concern from European policymakers, who committed to responding further as needed to restore inflation in Europe. Additionally, and obviously, continued declines in global commodity markets are both deflationary and an ominous sign for underlying global economic health. Economic data in the US has shown some recent weak spots, such as the Empire State manufacturing printing at a contractionary level, and importantly the Employment Cost Index (the Fed’s preferred measure of wage inflation pressure) registered the weakest reading in the 20-year history of the series. Lastly, quantitative easing is economically stimulative through the wealth effect; more buoyant asset prices lead to incremental consumption. Risk asset markets, especially credit, have been anything but buoyant in recent weeks. The reverse wealth effect — major sell-offs precipitating further fundamental weakness — should concern policy makers even though they would never say so.
These facts leave the Fed in an awful position. Clearly they feel compelled to remove the extraordinary stimulus, which our conscience tells us has just gone on for too long. It simply feels wrong for an entire generation to develop under significantly negative real interest rates. If we can’t wean ourselves now, then when can we? As a hypothetical policymaker I would be genuinely concerned that the economy might reach the end of this business cycle with policy rates still at-or-near the zero lower bound. However, I would be even more concerned that hiking rates too soon might accelerate the cycle endgame, especially after the August we’ve had. I would blink.
I have characterized the global central bank response to the financial crisis as our economic “original sin.” The worldwide fiat currency regime traded persistent financial repression in exchange for avoiding a worldwide depression. As a result, on some level I am not surprised that normalizing policy even on the margin is frustratingly difficult. I think it may never, ever be the same.
The timing of the depreciation of the CNY last week followed shortly after the publication of the IMF’s review of “Method of SDR Valuation – Initial Considerations”. Discussed quite prominently in the document are the operational implications of including CNY in the SDR (special drawing rights) basket. Key issues mentioned include how to identify suitable representative exchange rates and the timing of those marks. The existence of the official fixing which is quite different than the market transacted rates and the deviation between offshore and onshore exchange rates were noted to raise potential concerns.
While many commentators in the past week have formed a narrative about this latest Chinese move via the lens of currency war or competitive devaluation, we believe the primary motivation of the policymaker remains focused on joining the SDR club. When one browses through the various PBoC press statements following the move initiated last Tuesday, one can find the axis of discussion revolves around issues raised in the IMF document (see link above) down to the fixing rate determination, extension of trading hours and narrowing the offshore/onshore gap. Subsequent press conferences and interviews further reiterated no intention to pursue depreciation as a policy and fundamental factors such as high growth, favorable balance of payments and demand for CNY assets are supportive of the currency.
One needs to also consider in the context of the USD move and the semi-peg CNY experienced in the past 12 months. In both NEER and REER terms CNY has markedly appreciated along with the DXY (charts below) to the tune of 15%. Some alleviation of this pressure is necessary and by migrating to a less managed/more floating regime allows policymakers to be more flexible in regards to monetary policy. This move last week by the PBoC should reduce future gap moves and introduce more two-way volatility. This will hopefully have the side benefit of instilling more risk management discipline to foreign currency Chinese borrowers to hedge appropriately and reduce structural FX carry trades.
Given the expected forthcoming rate hike by the Fed and brighter prospects in the US, the broader USD strength will likely persist. However, China should remain one of the less dirty shirts considering the relative macro indicators from the rest of developed market and emerging market countries. We are cognizant that depreciation pressure on the rest of Asia has increased as a result and recent rhetoric suggest some may use the Chinese move as an excuse to encourage further depreciation of their currencies.
On Chinese growth, we do not expect this move to have material impact and that more will need to be done from the fiscal side to stimulate. Local government and infrastructure spending should be prominently featured in the second half of this year as we have written earlier in this blog.
While local interest rates have risen since last week, we attribute that to the PBoC intervention in the FX market to stabilize excessive depreciation expectations which has led to a temporary absorption of liquidity. We expect further cuts in RRR and open market operations are in order to bring back the conditions to an accommodative level.
Lastly we remain overweight in China USD credits. While there might be concerns about currency mismatch in liability, the overall percentage is not alarming. While we are vigilant on those issuers that might be vulnerable, we also want to note that the onshore CNY market has been open and active for issuers while providing a lower funding cost vs USD markets. This is anticipated to bring down USD bond supply for a better technical picture.
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