After a wild month of August that saw mayhem on the global markets, the all-but-certain September target for the Federal Reserve to increase the federal funds rate is now greatly in doubt. In fact, the tide may very well be turning toward a restart of QE (the opposite of tightening monetary policy), as many Fed skeptics predicted during the tapering off of quantitative easing.
There are five clear factors that could push back rate hike:
- Slowdown of the Chinese economy
- Dollar strength causing disinflation (chronically low inflation)
- Energy crash causing disinflation (related to #1)
- ECB hinting at more QE (PBoC may, as well, related to #1)
- Volatility in equities
Figuring Out the Fed
Analysts at TD Securities have joined their peers at Barclays in expecting the first rate hike by the Fed not to come until next March. Due to the downturn in the global markets over the course of this month, projections for when the Fed will move have softened. New York Fed President William Dudley recently called the case for a September rate hike "less compelling," while influential ex-U.S. Secretary of the Treasury Larry Summers called a rate increase in September a "serious error."
There are, however, mixed signals, proving that the Federal Reserve has not arrived at a single, unified consensus about the appropriate timing of the first rate hike. St. Louis Fed President James Bullard expressed doubt that the volatility on the markets actually changes the outlook for the Fed, dismissing chronically low inflation as a reason for the Fed to hold back. (Chair Yellen and the statements released by the FOMC have targeted 2% inflation as a healthy level for the economy; inflation has thus far run well below this target.)
Joining Bullard in dissenting from the view that the Fed needs to shift gears and accommodate shaky markets is Cleveland Fed President Loretta Mester, who still sees a strong case for lifting rates off of their current bottom. The Fed is currently holding its annual gathering at Jackson Hole, Wyoming, though Yellen will not be in attendance.
Some have suggested that the rate hike could simply be delayed until October rather than abandoning the 2015 calendar year entirely. The Fed also has the opportunity to raise rates this year after their December policy meeting.
Renowned economist Mohamed El-Erain has characterized this as the Fed's "Goldliocks Problem"—searching for market conditions that are not too hot, but not too cold. Given the recent spate of volatility, this is becoming more and more difficult to count on.
Some analysts believe China's real rate of economic growth could be only half the official government estimate of 7%. This may mean years of lower demand for everything from raw commodities to consumer goods. Although its direct affect on the U.S. economy should be minimal, given that U.S. exports to China are less than 1% of U.S. GDP, the effect on global interest rates is the larger problem.
Really, it is a crisis of confidence in China: Investors worldwide now have serious doubts about Beijing's ability to control their domestic markets. This is the case in nearly any economy; ever noticed how often analysts and prognosticators are focused on "sentiment" and "confidence"?
MarketWatch points out that market activity goes haywire when participants cease to believe in the ability (or competency) of central banks to manage volatility and successfully perform damage control. This happened in 2008 with the Federal Reserve and may once again be playing out with the People's Bank of China today. Some estimates place China's contribution to global growth at 50% over the last several years, a staggering number. If China slows down and its production can't be replaced, the global economy could plunge into recession.
According to the Wall Street Journal,
"China’s combination of overcapacity and a slowing economy has already sent commodity prices careening lower. That will show up in U.S. prices for not just raw materials but the goods those raw materials feed into. Moreover, China’s overcapacity is pushing it to charge less for what it exports, and is pushing down the prices for consumer goods globally."
It remains to be seen if the PBoC decides to engage in more easing. The Chinese central bank already cut its rates for the 5th time in 9 months last week in addition to actively influencing the value of the yuan. China may be more likely to jump on the QE bandwagon if the ECB pulls the trigger on more QE first.
Bonds and Currencies Impacted
If the dollar continues to gain, it's unavoidably going to increase the disinflationary pressure on prices in the U.S. in addition to robbing U.S. companies of overseas profits. The USD gained almost 3% this week, rebounding to about 96.0 on the DXY. This brought the euro down from as high as $1.16 back to $1.12.
Treasuries fell considerably this week, sending 10-year bond yields back into the 2.15% to 2.20% trading range thanks to a large selloff of U.S. debt by Chinese investors. China holds more Treasuries than any other foreign entity, accounting for nearly 10% of the $13-trillion Treasury market. Any added selling pressure by China could send yields even higher and lead interest rates to rise.