China and the dilemma of US monetary policy

The summer that is now coming to an end has been marked by increasing doubts regarding the sustainability of growth in China and its dramatic consequences on financial markets in terms of the sharp upswing in volatility and big stock market losses. After the bursting of its stock exchange bubble, and also to handle the risk of the economy suffering an abrupt slowdown, the Chinese government has adopted more accommodative monetary policies, among others, by both devaluing the renminbi and injecting liquidity into the markets: lowering interest rates and reducing the cash reserve ratio.

These measures are a logical reaction given the country's economic and financial situation as monetary policymakers believe they have room to relax financial conditions given that inflation is still below 2%. Although it is true that economic agents are now much more in debt than before, it is also true that the Chinese state has substantial resources, especially in international reserves, to tackle potential financial crises. But the reaction of the Chinese authorities must also be interpreted as a response to an international monetary environment that has become increasing adverse for China. The country has allowed the renminbi to appreciate considerably over the last few years although, more recently, it has maintained a relatively stable exchange rate against the dollar. In a context of growing disparity (real and expected) between monetary policy in the US and the other large monetary blocs (the euro, yen and pound sterling), this policy was causing the renminbi to appreciate even further against the currencies of many of the country's trading partners. The decisions taken by the Chinese government are also an attempt to alter this trend.

Such questions regarding China's growth, as well as doubts regarding other important emerging countries and the fragility shown by financial markets have placed the Federal Reserve (Fed) in an awkward position. In its coming meetings it will have to decide whether to embark on the interest rate hikes tentatively announced before the summer. The situation we have just described does not help the Fed to carry out its original plans but there are compelling reasons for the US monetary authority not to postpone the gradual normalisation of its monetary policy for too long. Arguments of a domestic nature (strong growth, very low unemployment and stable inflation) are quite clear and, ultimately, the Fed's mandate is to respond to the evolution of these variables.

But on this occasion a serious external argument must also be added. The US central bank plays a key role in the international monetary system and the cyclical position of the US economy allows it to embark on a path of relatively restrictive monetary policy; i.e. compared with what is happening in other important monetary zones. This change in direction is relevant and necessary to stop the increasing global expansion in liquidity which the main central banks have become entangled in over the last few years. This monetary policy war has led to competitive devaluations and resulted in a global environment of abnormally low interest rates. Such a situation makes it difficult to assign investments correctly, causing speculative bubbles in real and financial assets with excessive leveraging and risk-taking on the part of many agents.

It is true that exercising this leading role has a cost for the US, principally in terms of the appreciation of its currency and the consequent impact on net exports. But the US economy can absorb this cost relatively easily, just as it can handle the indirect impact of slowing growth in emerging economies. In any case it looks like the events of the summer may alter the Fed's plans. Political circumstances (the start of primaries for the presidential election) and the huge pressure exercised by the downward trend in capital markets suggest that the start of monetary normalisation will be postponed.

If this scenario is confirmed, the decision will be presented in terms of the risks associated with making a mistake at the present time. And this might actually be the case, namely that the consequences of mistakenly raising interest rates might be worse in the short term than mistakenly not raising them. But what about the long-term consequences? In this case the balance of risks might even be in favour of raising interest rates, an alternative which (although costly in the short term) could help to prevent serious financial instability in the long run.

Jordi Gual

Chief Economist

31 August 2015