- In September, the Fed justified its decision to delay the launch of rate hikes by pointing to risks external to the United States
- Setbacks in foreign economies are more likely to hold back the Fed if these are due to declines in commodity prices or deleveraging from high debt levels
- The threat of China “depegging” may be even more important.
"In mid-September, the US Federal Reserve(Fed) justified its decision to refrain from launching a rate hike by referring to external economic risks.” Says Oliver Adler, Head of Economic Research, Credit Suisse.Which types of risks is the Fed most likely to be concerned about?
“The most obvious impact of the external world on the US economy is via demand for US exports.” He declares. Weakness abroad reduces the latter, slows US GDP growth and thereby depresses US inflation. If the USD appreciates as external demand weakens, the trade effect is amplified: US exports lose out to those of countries with weaker currencies and US imports rise while import prices fall, further dampening US inflation. Explains the expert.
The degree to which the USD appreciates in response to weak foreign demand depends to a considerable degree on the nature of the shock that has caused the foreign slowdown.“If, for instance, a foreign economy slows because its central bank has raised interest rates to counter economic overheating, the foreign currency is supported and the USD’s appreciation is limited. “He adds.
“Recent shocks were not of this nature. The most significant negative event, especially for a number of emerging markets (EM) has been the sharp decline in commodity prices.” Explains Adler. This has led to a sudden loss of income for commodity exporters and a sharp depreciation of their currencies. By default, the USD was boosted. Second, and in part as a result of lower commodity earnings, the risk increased that debts that were built up during the EM boom years would become unsustainable; currencies responded with further declines, again boosting the USD.
“However, it is our sense that financial stability concerns weigh more heavily in the Fed’s calculus than trade– after all, exports to all EM are only about 4% of US GDP. “ He adds. “Indeed, if US interest rates rise in a situation in which EM are financially fragile, then the USA as well as other economies can be negatively affected: most important, typically, is the impact via banks that are exposed to EM, but declines in asset prices can have added negative wealth, confidence and financing effects. While US banks are less exposed to EM than in the EM crisis period of the late 1990s, the financial linkages remain strong. “
“The most important concern for the Fed is arguably that China might “de-peg” its currency from the USD; that becomes more likely if US monetary policy tightens and boosts the USD. A weaker CNY would not only weaken US exports to China, but can also cause considerable financial instability, as the August episode demonstrated: depreciation expectations amplify capital outflows, and FX interventions are needed to stem them. This occurs in the form of sales of US assets, including US Treasuries, which tends to unsettle USD asset markets. With geopolitics suggesting that the USA is averse to seeing the CNY achieve reserve currency status too fast, the pressure for the Fed to consider China’s interests has increased,” concludes Adler.