Fed Holds Fire—China Matters

The Federal Reserve’s decision to not raise rates today was the market’s consensus expectation. Nonetheless, U.S. and foreign bond markets have rallied on revised expectations for Fed policy. With four members of the Federal Open Market Committee (FOMC) now forecasting that interest rates will lift off only in 2016 or later, markets are now putting significant weight on a rate hike only next year.

More importantly, the forecast of FOMC participants—the “dot plot”—shows that the policy rate is only expected to reach around 2.5 percent in 2017 and 3.5 percent in the longer run. So whenever liftoff occurs, the Fed wants you to know that rates will increase very slowly in the coming years. Easy monetary policy is here to stay.

The Fed’s statement highlights the role of international developments in their decision. “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.” Perhaps they would have held fire even if there were not for developments abroad, but it’s notable that Janet Yellen’s press conference highlighted global uncertainties (and their knock-on effects on inflation and inflation expectations) as important risks to the the U.S. outlook. It looks possible that the crisis in China, along with the decline in commodity prices and tightening in global financial conditions associated with this shock, was a decisive factor.

By itself, the China news is a thin argument for not raising rates. The roughly 2.7 percent depreciation of the RMB against the dollar over the past month, and a roughly 0.5 to 1 percent mark-down in Chinese growth (the size of the reduction in growth forecasts over the past month in many market outlooks), would reduce U.S. growth by only about 0.1-0.2 percent. Hardly a reason to put off a move justified by an improving labor market and a forecast of continuing solid U.S. growth. Further, resolving the uncertainty of U.S. rate liftoff, combined with a strong signal that interest rates would move up only slowly, might well have been neutral for markets in the current environment. But clearly, on net, international developments continue to be a drag on the U.S. outlook, and conversely a moderately-growing U.S. economy can’t sustain growth abroad on its own.

Any story whereby a China crisis has a material impact on the United States likely assumes either that there is much worse to come from China, or, more materially in my view, that the crisis in China spreads through emerging markets, affecting in particular both commodity exporters such as Brazil and countries (especially in Asia) with close ties to China and high levels of private debt and leverage. Already, the Chinese news has caused emerging markets to fall and capital outflows from these countries to accelerate, and if these trends continue we could see a move in the trade-weighted dollar and a decline in global demand that could be material. Stated more directly, China will remain a global risk and contagion a global concern. The challenge is that these scenarios will take some time to play out, and in any case it could be many months before they are ruled in or out. At some point, the Fed will need to accept that global risks and the volatility they generate are an enduring feature of markets and not a reason for indefinite inaction.