Let’s not kid anyone: when the Federal Reserve speaks of “global economic and financial developments” in justifying delaying an interest rate rise, they are talking about China.
That implies a long wait, as China is engaged in a needed but dangerous multi-year effort to transform itself into a consumer-based economy. It also ties Fed policy to the decisions of Chinese policy-makers, a gang who not only can’t shoot straight but whose idea of a market intervention involves a certain unattractive raw forcefulness.
Very little of importance changed in the statement released by the Federal Open Market Committee, other than one line:
“Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term,” the statement said.
Fed chair Janet Yellen expanded on this at the press conference, drawing an explicit line between the decision and developments in China.
“We focused particularly on China and emerging markets,” Yellen said.
“We’ve long expected to see some slowing in China as they rebalanced their economy.”
The issue, according to Yellen, is “whether or not there might be a risk of a more abrupt slowdown” in China than consensus had expected. She also mentioned, in an understated way, questions over Chinese policy-makers’ “deftness.”
“Developments we saw in financial markets in August in part reflected concerns there were downside risks to Chinese economic performance,” she said.
Let’s walk through this slowly.
First off, yes, there are concerns about other emerging markets, notably Brazil, whose currency is down sharply and which is now a full-fledged junk credit. Yet while Brazil, and many other emerging market countries, are all unhappy now in their own particular ways, the common denominators are two:
falling demand from China for raw materials and falling capital flows from abroad on the expectation of rising U.S. interest rates.
So the Fed is worried about emerging markets because: China and the Fed.
This brings us back to China and the very real risks of putting it so close to the center of the Fed’s policy-making matrix.
China is going to be suffering transitional problems for a long time. The process of switching from over-investment to consumption is a very long one, upsetting the debt-reliant model China has used since the financial crisis.
As for Chinese financial markets, they are a volatile mix of fairground speculation and show trial, not the sort of process a sensible central bank wants to find itself attendant upon.
Important but opaque
This both implies a potentially long delay in raising U.S. interest rates - it will be years until the transition is stable - and a heck of a lot of uncertainty. Given the opacity of Chinese data and volatility of its markets, investors are really going to struggle to understand how this interacts with Fed decision-making.
It is impossible to gainsay China’s importance to the global economy, and in turn to the main legs of the Fed’s mandate: inflation and employment. Clearly if the Fed thought there was a decent-sized risk of a global recession starting in China and radiating out, then this decision is a good deal easier to defend.
That’s certainly possible but, significantly, Yellen and the Fed made mention not just of China’s economy but of developments in financial markets.
Here is where the decision by the Fed to delay, or wait, seems unwise and inconsistent.
Did the Fed see the sky-rocketing of Chinese mainland stocks - with a tripling of the market capitalization of the Shenzen and Shanghai composite indices in the year to June - as a reason to tighten? Well if they did, they certainly didn’t mention it.
Remember that this rally was characterized by leverage and by the sucking in of unsophisticated investors, many without a grade school education.
So while the spectacle of Chinese stocks first rising by the GDP of Japan and then falling, in only 22 days, by the GDP of Britain is instructive, it is a hard thing around which to build sensible policy.
And as for Chinese policy-makers’ “deftness,” I share Chair Yellen’s concern. China’s frantic efforts to reverse the sell-off have been heavy-handed, probably counterproductive and left us with Chinese financial markets which contain even less information than previously. That’s before we get to the ugliness of televising “confessions” of financial journalists.
Perhaps the Federal Reserve is better than the rest of us at looking through this and seeing the underlying reality of China’s financial system.
Perhaps not.
Best-case scenario: the Fed was spooked and will go in October.
If they mean what they say about China we may have a long and uncertain wait.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
