US central bank knows it cannot risk triggering shocks in China

William Pesek

China, as everyone knows, has empowered its economy by becoming the global factory. But is it also now manufacturing Federal Reserve policy?

It is hard not to conclude as much, given the Fed’s about-face on U.S. interest rates. Chairman Jerome Powell shifted to dove from hawk in early January after, in part, Apple Inc.’s profit warning. But the prompt for the change was less the iPhone’s travails than the force behind it.

“The Chinese economy is slowing down — it is slowing up a lot in consumer spending,” Powell said in Washington on Jan. 10. “Weak retail spending; everyone has seen the Apple news.”

Powell’s comment was made in the context of explaining what worries him about 2019. His China focus is telling. It shows there is less reason to give President Donald Trump’s anti-Fed rhetoric credit for Powell’s softening than Fed’s critics allow.

China surfaced again in Powell’s post-Fed-meeting press conference on Jan. 30. That was the day many economists reckoned Trump’s talk of a “crazy” Fed had cowed the central bank into submission.

In reality, the Fed would indeed be crazy to ignore the fact that China is a huge, and growing, blip on its radar. China’s slowdown is reducing inflation risks globally, in some ways doing Powell’s job for him. Also, no official wants to be blamed for crashing the world’s second-biggest economy.

Nothing good would come from one half of the Group of Two falling into financial distress. That is why, as 2019 unfolds, China’s imbalanced economy will act like an “electric fence” for the Fed, says Brian McCarthy, founder of Connecticut-based research firm MacroLens.

Clearly, Trump’s tariffs are a key variable driving China to its slowest annual growth since 1990. Gross domestic product growth of 6.6% in 2018 looks set to become ever weaker in the light of more recent data, including in exports, manufacturing and investment.

The rate-hike pause is a welcome respite. Powell’s team has a domestic mandate, of course. Given the blockbuster January jobs report — the U.S. added 304,000 in nonfarm posts — the Fed has ample justification for its three tightening moves last year. Yet that 75 basis-points of austerity last year — putting rates into the 2.25% to 2.50% range — caused a financial storm in Asia.

India, Indonesia and the Philippines — all with deficits on the external as well as fiscal accounts — saw currencies go into free fall.

Aggressive footwork by their central banks followed quickly, with all tightening several times. Coincidentally, New Delhi, Jakarta and Manila are all in election years. Patience at Fed headquarters, it follows, will take pressure off emerging markets, and their politicians.

The benefits are not clear-cut, though. While Japan and South Korea are happy to see less market chaos, the yen and won could skyrocket, and damage their exports.

Trump makes no secret of his desire for a weaker dollar. The protectionist-in-chief sees exchange rates as a means of reviving U.S. manufacturing. Trump also wants to punish Asian nations he views as stealing jobs.

A yen rally would ruin Prime Minister Shinzo Abe’s year. With Abenomics well into its seventh year, Japan’s prime minister desperately needs executives to share profits with workers. That wealth transfer is unlikely if the yen surges toward 95 to the dollar (from 109 now). That is the figure being bandied about by former Bank of Japan officials including Shigeto Nagai.

A surging yen this year might prod BOJ Governor Haruhiko Kuroda to venture further into the monetary unknown to rein in the currency.

But, here, Trump is a constant wild card. Any move to intensify his trade war would put markets in a “risk-off” crouch, boosting the yen. In times of trouble, says strategist Mazen Issa of TD Securities in New York, the yen becomes the “default anti-dollar, and hedge for an uncertain outlook.”

South Korea’s president Moon Jae-in also has reason to live in daily fear of a won rally. Exports dropped 5.8% in January from a year earlier, the second monthly drop in a row. Headwinds complicate Moon’s ability to reduce record household debt and address 8.6% youth unemployment. They reduce his latitude to curb the conglomerates that stymie efforts to craft a less trade-reliant model.

But China is the real risk. Fears of a hard landing worried the Fed, even before Trump and Powell came on the scene. In late 2015, as then-Fed Chair Janet Yellen inched toward Washington’s first rate hike since 2006, Chinese markets quaked. The resulting yuan drop had Beijing selling roughly $60 billion of U.S. Treasury securities per month to stabilize the exchange rate.

At the time, economist Barry Eichengreen argued China was already yanking away the easy money punchbowl for Yellen. Econbrowser blog writers James Hamilton and Menzie Chinn called it “outsourced monetary tightening.”

Between December 2015 and December 2018, Yellen and Powell grabbed the reins, and firmly so. In 2019, though, it is hard not to conclude that monetary decisions are again being driven by President Xi Jinping’s economy.

After the 2008 “Lehman shock,” the Fed and People’s Bank of China moved in the same direction, churning liquidity into markets. Fed rate hikes and Trump’s trade wars are now upending that cozy relationship.

One wonders if the Fed should start asking a senior Chinese official to brief policymakers on where the economic cracks lie. True, the Fed has 12 districts scattered around the U.S. Over the last decade, though, China has arguably become an unofficial 13th sphere of Fed responsibility. If Trump broadens his assault on Beijing, the argument for a Fed rate cut strengthens.

The receding tide of trade earnings is leaving Asia’s biggest economy more vulnerable to capital swings. China faced an earlier exodus risk between 2014 and 2015, when it spent nearly one-quarter of its currency reserves battling speculators. Now, China is far more vulnerable.

An overly-tight Fed that starves Beijing of liquidity threatens China’s credit bubbles, putting downward pressure on mainland growth and the yuan. These feedback effects, in turn, undermine the U.S. stock rally Trump saw as supporting his legitimacy.

Apple, of course, is just one example. It is rare, though, to hear a Fed leader citing a company’s troubles. But everyone knows the real concern is China. That will remain true for the Powell Fed’s monetary deliberations from here on out.

William Pesek is an award-winning Tokyo-based journalist and author of “Japanization: What the World Can Learn from Japan’s Lost Decades.” He was given the 2018 prize for excellence in opinion writing by the Society of Publishers in Asia, for his work for the Nikkei Asian Review.

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