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Why the Fed Is Watching China Closely

The real reason the U.S. avoided a rate hike.

October 7, 2015

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china flagIt is often cited that the U.S. Federal Reserve’s job is to manage interest rate and monetary policy in the United States in order to achieve its twin objectives of low inflation and low unemployment. In other words, what goes on elsewhere is not part of the Fed’s mandate. Frankly, my view is that this is a quaint and terribly outdated notion and recent Fed pronouncements make it abundantly clear why.

As everyone knows last week the Fed deferred its much anticipated September interest rate hike, once again. Although Fed Chair, Janet Yellen, and several of the Fed Governors have said that they are data driven, clearly this not the case as the data indicates that the U.S. economy has returned to reasonably good shape.

The Fed is now paying attention to two important international signals. First, world trade is contracting very sharply and has fallen by 15% during 2015. The fall is synchronous with the termination of QE3. It is reinforced by a singularly monotonic slide in commodity prices.  Termination of QE3 provoked a rise in the US.. dollar as markets expected the next move would be rise in U.S. rates.

More interesting is the fall in U.S. import prices causing the value of U.S. imports to fall by 10% year to date. This has reduced the growth in global liquidity, one of the main engines for global growth. The rise in the U.S. dollar has also reduced U.S. exports abroad again having the impact of slowing growth.

But the most important signal the Fed is monitoring is coming from China. The yuan is effectively pegged to the U.S. dollar. Raising U.S. rates will strengthen it, as we have already seen from the expectation that U.S. will increase rates. This means the yuan was similarly strengthening against other major currencies. China’s reaction was to devalue the yuan by 3%, a picayune devaluation by any yardstick.

Why would China have bothered was the question on many observers minds?

Many have speculated it was because China wished to show responsible restraint in managing its currency to hasten its inclusion in the International Monetary Fund’s Special Drawing Rights (SDR) package of currencies.

I submit that there is another more nefarious reason to which the Fed is hyper sensitive.

China is gently sending the Fed a signal. Raise your rates and strengthen your dollar and we will respond by devaluing the yuan to maintain our level of exports. Under traditional metrics this would be no big deal, but we are talking about an economy that rivals the U.S. in size.

China is threatening to export deflation to the U.S. by reducing the yuan. As the U.S. is China’s biggest customer by far, the impact on inflation (read deflation) of a continued yuan devaluation would be significant.

In a world where everyone is trying to inflate, deflation is anathema. This is a battle the U.S. cannot win.

China has much lower costs of production than the U.S. and can export deflation for a long time, in the process completely wrecking any plans the Fed has to restore normalcy to its own monetary policy. Consequently, the Fed must pay attention to and acknowledge China’s needs, not simply its own.

China’s exports are falling not just relatively but also absolutely. Its economic model of export-led, investment-driven growth is currently failing, which is limiting the Fed’s ability to conduct domestic monetary policy.

No one currently believes that the Fed should continue it low interest rate regime. The problem is that international events are making it impossible to do anything about it. I fear the next move of the Fed may be to restore quantitative easing.

It appears to be the only way to increase global liquidity as it has been declining ever since QE3 ended causing the incipient global recession. Yes the Fed is the world’s central banker…

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