China turmoil clouds Fed rate outlook

The plunge in Chinese stocks, which on Monday triggered a sell-off on global markets including Wall Street, will only deepen those worries and embolden those on the FOMC who are pushing back against arguments for a move as soon as September 17.

“If anything it will cause them to delay,” said Ted Truman, a former Fed official now at the Peterson Institute for International Economics. If the Chinese sell-off is symptomatic of a deeper weakness in China’s economy, “it will have implications for the global economy and on inflation outlooks”.

That said, the Fed is unlikely to jump to any instant conclusions about the market ruckus. There are three weeks to go, as well as a key jobs report, before the Fed will make its September decision. US domestic economic indicators remain resilient, and market gyrations can quickly subside.

But overseas factors — among them the Greek stand-off and dollar upsurge — have repeatedly intervened this year to muddy the waters as the Fed prepares to hike. Indications about how officials view the latest turmoil are likely to emerge at the Kansas City Fed’s annual gathering of policymakers in Jackson Hole, Wyoming, this week. Debate is likely to centre on persistently subdued US inflation numbers, as well as the specific channels China’s woes could feed back into America’s own outlook.

The most obvious one is the risk of a contagious loss of confidence in global markets, which will have negative effects on household wealth in the US and in corporate optimism. Michael Feroli, US economist at JPMorgan Chase, said the Fed would not want to appear “too reactive” to short-term moves in the US stock market.

But he added: “At a certain point it does affect household wealth and consumer spending and is correlated with credit spreads, which have been widening — implying a higher cost of capital and slower capital spending.”

Even before Monday’s sell-off, financial conditions have been tightening in the US, said Lewis Alexander, an economist at Nomura. His bank’s index tracking equity prices, corporate credit spreads, and surveys of credit availability has dropped sharply since the July FOMC meeting, implying the contribution of financial conditions to growth over the next 12 months has fallen by 0.4 percentage point.

Barclays economists on Monday shifted back their call for the first Fed rate hike to March 2016 from September 2015, arguing the central bank would not want to further destabilise markets.

Further hampering growth has been the persistent strength of the dollar, which played an important role in derailing calls for a Fed rate rise earlier this year. The latest Fed minutes cited some participants warning that a divergence between US interest rates and rates overseas might lead to further appreciation and extend the weakness in net exports, after the trade-weighted dollar rose 15 per cent from June 2014 to March 2015.

A deeper risk may be that China’s equity market rout signifies a more serious slowdown in an economy that has played an outsized role in driving global growth over recent years. Already the currency depreciation by China two weeks ago set alarm bells going across emerging markets.

Stephen King, senior economic adviser to HSBC Bank, argues that China has played the critical role of “consumer of last resort” in the global economy in recent years, but that it is no longer willing or able to play that part. The sell-off “reveals market anxiety about the global economy that should make central bankers think twice about raising interest rates”, he argued.

Faltering Chinese growth coupled with weaker commodity prices and a higher dollar could further delay the prospects of a return of US inflation to target. Already market-based inflation expectations in the US have been sliding. With the US crude oil price below $40 a barrel on fears about ebbing global demand, the Fed may have to further push back its expectations for when inflation returns to the 2 per cent target, as well as pencilling in a further drag from low oil-related investment.

However, the cheaper energy costs should also provide a fresh impetus to consumer spending. And the broader domestic story in the US remains strong, with the US jobs market continuing to create jobs at an average pace of 246,000 a month for the past year. The steady march of the US towards full employment has been the key anchor behind Ms Yellen’s expectations that the Fed will raise rates at some point this year. The question is whether overseas hazards will get in the way.


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