Threat from the Far East

The devaluation of the Chinese currency is influencing U.S. monetary policy as expected. U.S. financial experts are hardly in unfamiliar territory at this time. However, experience shows that the situation is subject to change.

New York. At first glance, the move by the Chinese central bank to devalue their currency by three percent over two days should have no impact on the policy of their American counterparts. But only at first glance.

Experience shows that the situation is likely to appear quite different upon a second glance. When the effects of the devaluation become clear in America, the U.S. Federal Reserve won’t be able to ignore them. Even if they increase interest rates in September as experts expect, the first increase in nine years, China’s wake will affect the course of future monetary policy.

Still, Americans are having their mettle tested. Bill Dudley, head of the New York Fed, expressed understanding on Wednesday for the Chinese decision. “If the Chinese economy is weaker than maybe what the Chinese authorities anticipated, it is probably not inappropriate for the currency to adjust in consequence to that weakness,” he said. He also pointed out that the Chinese yuan had risen significantly, due to its peg with the U.S. dollar relative to other currencies. [http://www.reuters.com/article/2015/08/12/china-markets-yuan-fed-idUSN9N0X500H20150812]

Michael Feroli of J.P. Morgan, one of the most well-known Fed experts in the USA, argues similarly. By his account, the estimated effect of the devaluation on U.S. growth is minimal. Therefore, he believes that the Fed shouldn’t be influenced by the Chinese decision.

But when the Europeans started their soft monetary policy last winter and the euro weakened significantly, reactions were similar. The tune that experts and policymakers followed was that America is strong, the step made by the Europeans was overdue and it was good for the global economy, so we shouldn’t worry ourselves. The first reactions to the fall in the price of oil were similar. It was even considered positive for the U.S. economy. In the months that followed, the voices that warned of the impact of a strong dollar multiplied. Even Janet Yellen, the head of the Fed, was surprisingly open about it.

While it’s not officially the job of central bankers to influence the exchange rate, which is why they usually don’t like to talk about it, they in fact almost always keep an eye on it. But the Americans have quickly realized that the strength of U.S. currency and the fall in the price of oil have virtually slowed inflation to zero, while at the same time leaving a mark on corporate earnings. Both are of importance to the Fed.

The dollar has risen for approximately a year by about 15 percent against other currencies. This was also due to the strength of the U.S. economy and the upcoming rate hike by the Fed. But the effect was exacerbated by the deliberate weakening of the euro.

Judging by this experience, a lot can be said regarding a likely decline of the serene picture of China. China is an important market for U.S. companies, such as Apple. In addition, the devaluation in China runs contrary to the efforts to bring jobs back to America. The devaluation reinforces the impression that the Chinese economy is a long-term engine of growth for the world that is also very clearly faltering. All of these will have repercussions on the U.S. economy.

The Fed won’t move its rate hike because of the China Effect alone. If a decision for the rate hike is on the chopping block in September, waves of unrest in China could make the difference and force a change in opinion. Furthermore, the question posed by capital markets immediately following the first hike is, “When is the next one?” And the threat from the Far East may well influence the answer.