The Chinese Economy and Fed Policy
CAMBRIDGE – Janet Yellen’s speech
on September 24 at the University of Massachusetts clearly indicated
that she and the majority of the members of the Federal Reserve’s
Federal Open Market Committee intend to raise the short-term interest
rate by the end of 2015. It was particularly important that she
explicitly included her own view, unlike when she spoke on behalf of the
entire FOMC after its September meeting.
Nonetheless, given the Fed’s recent history of revising its policy
position, markets remain skeptical about the likelihood of a rate
increase this year.
The
Fed had been saying for several months that it would raise the federal
funds rate when the labor market approached full employment and when
FOMC members could anticipate that annual inflation would reach 2%. But,
although both conditions were met earlier in September, the FOMC
decided to leave the rate unchanged, explaining that it was concerned
about global economic conditions and about events in China in
particular.
I
was unconvinced. I have believed for some months that the Fed should
start tightening monetary policy to reduce the risks of financial
instability caused by the behavior of investors and lenders in response
to the prolonged period of exceptionally low interest rates since the
2008 financial crisis. Events in China are no reason for further delay.
Consider,
first, domestic economic conditions, starting with the employment
picture. By the time the FOMC met on September 16, the unemployment rate
had fallen to 5.1%, the level that the Fed had earlier identified as
full employment. Although there are still people who cannot find
full-time jobs, driving the unemployment rate below 5.1% would,
according to the Fed, eventually lead to unwanted increases in
inflation.
The
current inflation picture is more confusing. The annual headline rate
over the past 12 months was only 0.2%, far short of the Fed’s 2% target.
This reflected the dramatic fall in energy prices during the previous
year, with the energy component of the consumer price index down 13%.
The rate of so-called core inflation (which excludes energy purchases)
was 1.8%. Even that understates the impact of energy on measured
inflation, because lower gasoline prices reduce shipping costs, lowering
a wide range of prices.
The
point is simple: When energy prices stop falling, the overall price
index will rise close to 2%. And the FOMC members’ own median forecast
puts inflation at 1.8% in 2017 and 2% in 2018.
So
if the Fed, for whatever reason, wanted to leave the interest rate
unchanged, it needed an explanation that went beyond economic conditions
in the United States. It turned to China, which had been much in the
news in recent weeks. China was reducing its global imports, potentially
reducing demand for exports from the US. The Chinese stock market had
fallen sharply, declining some 40% from its recent high. And China had
abruptly devalued the renminbi, potentially contributing to lower import prices – and therefore lower inflation – for the US.
But
when it comes to the impact of China’s troubles on the US economy,
there is less than meets the eye. China’s import demand is slowing in
line with its economic structure’s shift away from industry and toward
services and household consumption. This means that China needs less of
the iron ore and other raw materials that it imports from Australia and
South America and less of the specialized manufacturing equipment that
it imports from Germany and Japan. The US accounts for only 8% of
China’s imports, and its exports to China represent less than 1% of its
GDP. So China’s cut in imports could not shave more than a few tenths of
a percentage point from US GDP, and even that would be spread over
several years.
As
for the stock market – widely viewed as a kind of casino for a small
fraction of Chinese households – only about 6% of China’s population own
shares. The Shanghai stock market index soared from 2,200 a year ago to
a peak of 5,100 in mid-summer and then dropped sharply, to about 3,000
now. So, despite the sharp drop that made headlines recently, Chinese
shares are up more than 30% from a year ago. More important, wealth and
consumption in China are closely related to real-estate values, not
equity values.
Finally,
the renminbi’s recent decline against the dollar was only 2.5%, from
CN¥6.2 to CN¥6.35 – far below the double-digit declines of the Japanese
yen, the euro, and the British pound. So, on an overall trade-weighted
basis, the renminbi is substantially higher relative to the currencies
with which it competes.
Even
more relevant, the decline of the renminbi and other currencies in the
past year has had very little impact on US import prices, because
Chinese and other exporters price their goods in dollars and do not
adjust them when the exchange rate changes. While official US data show
overall import prices down 11% in the 12 months through August, this is
almost entirely due to lower energy costs. When energy products are
excluded, import prices are down only 3%.
So
the Fed is right to say that inflation is low because of the sharp drop
in energy prices; but it need not worry about the effect of major
trading partners’ lower currency values. And, again, when the price of
energy stops declining, the inflation rate will rise close to the core
rate of 1.8%.
So,
unless there are surprising changes in the US economy, we can expect
the Fed to start raising interest rates later this year, as Janet Yellen
has proposed, and to continue raising them in 2016 and beyond. I only
hope that it raises them enough over the next 18 months to avoid the
financial instability and longer-term inflation that could result from
the long era of excessively easy monetary policy.
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