Chinese currency and US monetary policy as the deflationary environment continues
The macro environment right now is disinflationary as many countries struggle with product and labour ‘overcapacity’. The missing element is demand to meet supply. I want to talk about Fed monetary policy and the new Chinese currency regime in that context, using recent events as a vehicle to understand what kinds of risks are present.
Let’s start with the Chinese first. Last week, I spoke of China as having been the marginal buyer of last resort during the post-financial crisis period. And I laid out reasons to question their ability to continue in that role. The very day I wrote this piece, China initiated a mini-devaluation and changed its currency regime in a way that I believe virtually guarantees currency depreciation going forward. That was last week.
And a lot has happened since then, particularly in emerging markets. FT Alphaville points to some good commentary from Deutsche Bank’s Jim Reid on how to read what has happened:
One of the big problems with China’s FX move is that although they’ve ‘only’ seen a 3% currency fall (in the onshore Yuan) since their announcement last week, others have subsequently followed suit either deliberately or via market [and oil based] pressure. The following countries have seen their currency depreciate at least 4% since last Monday (and using last night’s closing prices): Kazakhstan (leading the way with a huge 26% devaluation following the removal of the trading band), Russia, Ghana, Guinea, Colombia, Belarus, Turkey, Malaysia and Algeria. In fact, if we extended the analysis to include those that have seen at least a 3% depreciation then the number of countries hits 17 and unsurprisingly all sit in the EM bracket.Every day it feels like we’re hitting fresh cycle lows for a currency somewhere with yesterday’s highlights being the Turkish Lira briefly sliding past 3 against the Dollar for the first time ever, the South African Rand breaching a level not seen since 2001, the Ruble weakening to the lowest level since February and the Malaysian Ringgit returning to a 17-year low.
So whatever their intentions the Chinese have created an air of fragility around the globe. Markets will now surely have to firm up considerably for the Fed to pull the trigger next month. We stand by our long-term view that they’ll struggle to raise rates this year but acknowledge that if calm does breaks out they wouldn’t require much to pull the trigger.
I like these two paragraphs because it talks in terms of what I would call catalyst and contagion rather than cause and effect. China’s mini-devaluation currency move is not a game changer because of its size. Rather, it is a game-changer because of its signalling and its position as a catalyst for contagion into other emerging markets and into commodity markets. The Turkish Lira isn’t falling because the Chinese devalued their currency. But the Chinese devaluation was indeed a catalyst for a re-assessment of the situation in Turkey. And the same is true in sundry other emerging markets. Think of it like the Dubai World crisis that kicked off the European sovereign debt crisis in November 2009 as an exogenous shock with a sort of butterfly contagion effect.
And the reason the Chinese mini-devaluation is having this impact is that we are already in a disinflationary or deflationary environment. Commodity prices and emerging market currencies have been selling off for months. Countries like Brazil and Russia, which are supposed to be emerging market leaders, are in major recessions. And there was already much concern about China’s ability to continue absorbing raw material supply. The devaluation made clear that China would not be absorbing these materials in a way that put a floor on commodity prices. Hence the violent reaction in markets since then.
So what now? It still isn’t clear what China’s intentions are. I asked Patrick Chovanec about this yesterday on RT and had my own comments on the matter. See the video below
But neither Patrick nor I could give a definitive answer as to what the Chinese were up to. My friend Marshall Auerback told Ameera David on Tuesday that he believes the Chinese are trying to institute a controlled devaluation. And this makes sense to me. They had the first mini-devaluation move to take pressure off exports, just as the cabinet had suggested. But they could not do so precipitously – and so they instituted the new ‘market-based’ currency regime in order to facilitate this devaluation while giving lip service to the pledge of liberalizing its currency. The Chinese had to know that ‘market forces’ would mean devaluation at this juncture and for the foreseeable future, which is why I wrote the move virtually ensures fiurther devaluation.
Offshore markets show the Yuan trading below official levels, meaning the Chinese have to be massively intervening in the currency markets to prop up the currency, preventing further declines in the currency. That’s not a currency regime dictated by ‘market forces’. It is one designed to slow an automatic reduction in the currency level. Just today, China’s PMI factory gauge dropped to its lowest level since March 2009, coming in at a contractionary 47.1 for August, well below median estimates for a still contractionary 48.2. This tells you the Chinese economy is seeing further deflationary pressure that will impact EM and commodity spaces negatively. And it also guarantees further downward pressure on the Renminbi.
What does the Fed do then? Back in late July I said that, “I see the Fed looking through the inflation data, using the fact that oil prices are declining and that this should aid consumers as a reason to hike in September.” The Fed minutes were more dovish than that though and the expectation for a September rate hike has diminished significantly, causing markets to fall and bond yields to decline. While I think the Fed has been overly optimistic and have expected interest rates to decline, I was expecting the Fed to follow through with a rate hike. Now I am less sure this will happen in September if at all given the data.
In any event, a rate hike is not a make or break event in my view. Instead, we should think about the prospect that the burgeoning neo-Fisherite view that low rates for longer are deflationary and not inflationary is in fact correct. Noah Smith explains the idea this way:
the basic idea. The Fisher Relation says that nominal interest rates are the sum of real interest rates and inflation:
R = r + i
That’s not an assumption, that’s just a definition (actually it’s an approximation, but close enough). What I call the “Neo-Fisherite” assumption is that in the long term, r (the real interest rate) goes back to some equilibrium value, regardless of what the Fed does. So if the Fed holds R (the nominal interest rate) low for long enough, eventually inflation has to fall. This is exactly the opposite of the “monetarist” conclusion that if the Fed holds R very low for long enough, inflation will trend upward.
Here’s what I would say. I am less concerned about the impact of inflation expectations than I am about what I would call monetary dominance in a zero rate environment. I have talked a lot about monetary dominance in the past. See my articles about Philly Fed President Charles Plosser’s call for a limited central bank here, here, and here. The gist is that monetary policy is the only game in town. Fiscal policy has been sidelined and monetary policy dominance is de jure everywhere in the developed world from the US to Canada to Australia.
I would frame the deflationary problem this creates as follows:
After a financial crisis, policy makers have a choice of approaches between bank recapitalization, credit writedowns, monetary policy and fiscal policy to deal with the aftershocks. In terms of aiding private credit growth directly, writedowns and bank recaps are important because it gives the banking system the wherewithal to make new loans and it gives debtors the ability to repay in full. But these issues do not address underlying imbalances in an economy like low wage growth or low productivity growth that could hold back credit growth.
In the initial period post financial crisis, the US used all four levers to pull the US economy out of a deep slump. But since that time, monetary policy dominance has been nearly absolute. And this is in part because an increased percentage of the US economy is “financialized” from the commodities markets to the auto market, the US economy has become dominated by monetary interests, where industries are leveraged to monetary policy and asset prices.
Take the auto industry, for example. Last summer I wrote about a must-read piece of investigative journalism from the New York Times on auto subprime. “What they found was predation and fraud like what we saw in mortgages during the housing bubble. This is a $145 billion market and it is emblematic of risks that people are taking everywhere to get an extra yield pickup. We see it in leveraged loans and in high yield as well. Janet Yellen would have you believe that easy money is not producing this type of behaviour. The reality, however, is that when nominal rates are low, nominal returns are low and investors are unable to hit yield targets. And the result is excessive risk. Caveat emptor.”
The auto industry is increasingly dominated by rent-seeking. And we know that the auto companies’ profit engine is their auto loan servicing business. But the auto subprime market has made the auto industry financialization problem worse. This is why regulatory laxity and low interest rates go hand in hand. Rentiers need both low rates and lax regulations to continue to make gains on their assets as the economy reaches peak. And everyone is a rentier now. Look at subprime auto driving auto sales growth. That is clearly a predatory market. We have zero risk-free rates and high, predatory, even punitive rates in subprime auto at the same time. This is a clear regulatory failure that rentiers want — and are getting.
Where would auto sales be without this market? Retail sales? Once the economy starts to roll over, rentiers start bitching about regulation so they can continue to score, not through productive investment but predatory extraction. We are already there in this cycle. The issue with monetary dominance is whether resource allocation due to the liquidity provided by the Fed and other central banks will be distributed in a way that maximizes productivity and wealth. I don’t think it does, nor do I think resource distribution is fair. We’re going to see the consequences in the next downturn. What we are seeing through monetary dominance is enough to skew asset allocation markedly, and in a way that has real consequences for years to come. Think tech bubble and housing bubble.
At the same time, if you are going to hold rates at zero, then you are subtracting substantially from interest income in the private sector. And that basically means on net you are sucking money out of the private sector, which is deflationary. On the other hand, fiscal dominance, whereby you add net financial assets to the private sector via deficit spending in order to reflate the economy is inflationary. Thus, with monetary dominance everywhere, we have a situation in which the only thing counteracting the basic deflationary impulse of lower rates is asset price inflation and the attendant credit growth, with the hope that this leads to productive investment. Again, I don’t believe it is leading to productive investment. And that suggests that the Neo-Fisherite view that lower rates for longer is deflationary is going to borne out. Empirically this is clearly the case, by the way.
So I see the deflationary environment continuing unless and until we see wage growth in North America and Europe that leads to enough demand side reflation to meet the excess capacity on the supply side. The risk, of course, is that the deflationary shock of the Chinese currency regime change is the catalyst for a crisis before this can occur.