The Federal Reserve’s Monetary Policy Change and Global Financial Market Turbulence
In both the financial crisis and the post-crisis era, the Federal Reserve’s monetary policy is calibrated according to the performance of the US economy. But that inevitably sends waves across the global financial market. As the US Treasury Secretary in the Nixon administration John Connally put it, “The dollar is our currency but your problem”.
Spillover Effects of the Entry and Exit of QE
Spillover effects are the impact that major economies’ policies have on other countries or even the world economy. From 2009 to 2013, the Federal Reserve introduced three rounds of QE with a total asset purchase of over 3 trillion dollars to fight the financial crisis. Roughly speaking, Quantitative Easing, or QE, refers to the Federal Reserve’s ad hoc unconventional monetary policy when zero short-term interest rate still cannot bring the economy out of recession. It is essentially buying long-term bonds from banks and other financial institutions to adjust interest rate, lower corporate financing cost, inject liquidity into the market and push up inflation rate to expedite the recovery of the real economy. The Federal Reserve’s QE policy drove up prices in the three major US stock exchanges, brought down long-term government bond yields, and boosted American exports as a result of dollar depreciation. Growth rate climbed up from negative 8% in 2009 to slightly above 2% in the following years while unemployment rate declined from 10% in 2009 to 5% in October 2015. The spillover effect is that QE started the temporary capital flow from the US to emerging economies in the form of short-term investments, equity and bonds, which at one point propped up stock and bond markets there but also drove up exchange rates and inflation.
With three rounds of QE, the Federal Reserve’s balance sheet ballooned from 800 billion to 4.48 trillion dollars, which is unsustainable. The Federal Reserve must scale back its balance sheet, adjust the interest rate policy and return to financial normalcy eventually. As the US economy turns around, QE exit was put on the table. On 20 June 2013, the then chairman Ben Bernanke announced for the first time that the Fed would adjust and cut back on asset purchase in light of changing economic outlook. Starting from January 2014, the Fed began to reduce asset purchase on a monthly basis and ended QE3 as scheduled in October of the same year.
Several spillover effects emerged as the Fed ended its asset purchase program: first, commodity prices (which are denominated in dollars) plunged as a result of a stronger dollar, incurring huge losses and economic slowdown in resources and energy export countries; second, low prices of oil and other commodities exacerbated deflationary pressure worldwide; third, hot money flew from emerging market economies back to the US, further straining their currency, liquidity as well as stock and bond markets; fourth, emerging market economies had to bear higher financing cost and those with huge debts in dollars faced both exchange rate and interest rate pressure, leaving them vulnerable to debt problems or even debt crises.
Spillover Effects of the Time Lag Between Expectations and Execution of Interest Rate Rise
Following QE exit, Federal Reserve Chairperson Janet Yellen once said the Fed would maintain low interest rate for quite some time after the end of asset purchase, and raising rate too soon or too late would bring risks to America's economic recovery. If we look at Yellen’s remarks on multiple occasions, four conditions need to be in place before the Fed raises interest rate: steady growth of the economy, more sufficient employment; inflation rate is near or at 2%; and asset bubbles are growing. The three FOMC meetings between December 2014 and June 2015 all seemed to indicate that the conditions for an interest raise are not there yet and it was too early to “pull the trigger”.
IMF Managing Director Christine Lagarde warned that if the Federal Reserve raises interest rate prematurely or keeps monetary policy too tight, the recovery of the American and world economy might be undermined. The “doves” in the Fed also worry that, at a time when the Bank of Japan (BOJ) and the European Central Bank (ECB) were pursuing accommodative monetary policies to boost inflation and recovery, premature tightening of monetary policy would undercut America’s economic recovery. The Federal Reserve must be certain of the solid growth of the economy before it raises interest rate. On the whole, the American economy is on course to recovery in the post-crisis era, with better employment figures, moderate wage rise and varying degrees of warming in the property market. As oil and gas prices fall, household spending is now poised to go up. Despite these positive signs, inflation remains low, and the world economy and financial markets are not yet on an even keel. The FOMC meeting on 17 September 2015 hence decided to maintain the existing federal funds rate. The Fed is cautious in raising rate, but won’t wait until maximum employment and 2% inflation. In December 2015, the Federal Reserve finally decided to raise interest rate but compared with previous ones, this raise is both slow and moderate. On 16 March 2016, the Fed decided that it would maintain the target range for the federal funds rate at 1/4 to 1/2 percent. It would take a rather long time for the federal funds rate to spike from the 0-1/4 percent to the pre-crisis 4-4 1/2 percent, if at all. Such a cautionary approach in interest raise is to avoid shocks to the American economy, minimize the negative spillover effects, cushion the blow to the market and lessen the downward pressure on the economy as a result of exchange rates fluctuations and global capital flow. On the other hand, longer-term expectations on a relatively low interest rate means that bubbles are building up in the US asset market.
Spillover Effects of the Dollar Index’s Rise
The Dollar Index measures the value of the dollar relative to a weighted basket of six major currencies in the world. Its rise, which plucks nerves across global capital markets, is largely attributable to the following factors. First, QE exit, expectations of an interest rate rise and the actual rise pushed up the Dollar Index. It climbed up by 14% and 9% in 2014 and 2015 respectively. Though this momentum somehow dissipated when interest rate actually rose, the strong performance of the US economy helped propped up a moderately strong dollar. Second, despite the lackluster performance of the American economy in the first quarter of 2015, the fundamentals remain sound. According to forecasts by the Federal Reserve and the US Congress, the economy is expected to grow at 2.4% in 2016. As investors’ confidence in American assets remains strong, international capital is flowing back to the US. High demand for the dollar is a key driver of its appreciation. Third, never before have advanced economies been so divergent in their monetary policies. As the Federal Reserve begins deleveraging to tighten liquidity, the ECB and the BOJ are doing the opposite, which in effect, drives up the dollar. Fourth, the dollar is strengthened as a result of declining share of the oil in American imports and the narrowing of US trade deficit.
As the marginal utility of unconventional monetary policy dwindles, the dollar gets stronger. Now that risks of rupture in America’s debt chain have emerged, the Federal Reserve decided to sell the treasury bonds and other bonds it held. As interest rate in the US climbs up, capital naturally flowed back to the US. In the bond market, more capital brought down the bond yield as well as government’s financing cost. When capital flows into the stock market, companies find it easier to raise funds, which is conducive to the real economy. Getting the US treasury bonds and the dollar right can boost economic growth and ease the pressure brought by the crisis.
Nonetheless, in the context of economic globalization, changes in the Fed’s monetary policy and capital flow also produce “spillback effect”. If the Federal Reserve’s interest rate hike triggers panic or even crises elsewhere, the risks will eventually be transmitted back to the US. So it is important that the Federal Reserve heed the impact of its policies on other economies and the potential spillback effect on the American economy. In addition, a stronger dollar is not entirely in the interest of the American economy. First, it undercuts the competitiveness of America’s exports and trade deficit as a percentage of GDP will once again rise above 3%. Despite the small share of export in the US GDP, which is mainly driven by household consumption, the stronger dollar did cause a bigger and longer drag on American exports and made it harder to double exports as envisioned by President Obama. Second, a stronger dollar would increase corporate financing cost and dampen profitability. Third, imports became cheaper, keeping inflation rate low. America is heavily reliant on imports as the manufacturing sector only takes up 16% of its GDP. Fourth, the ultra-low interest rate has incurred more than 18.1 trillion dollars of debt on the federal government. A stronger dollar means more interests and heavier burdens on the borrower. In the fourth quarter of 2015, the US GDP only grew by 1%, much slower than in the second and third quarters. Coupled with the negative effect of a stronger dollar, the room for dollar appreciation is rather limited.
With its unique role in the international economy, the dollar is capable of producing huge spillover effects, positive or negative, on other economies through one way or another. Specifically, the surging dollar is a result of improving fundamentals of the American economy and stronger consumer demand, which means more imports from other economies. But a stronger dollar together with tax breaks and other favorable policies at home can also pull back American corporate investment from abroad, which will put strains, directly or indirectly, on financial market stability and asset prices of emerging and developing economies. As the Federal Reserve raises interest rate, room for arbitrage emerged and capital began to flow from emerging and developing economies back to the US. As a result, the US turned from a “pump” of global liquidity to a “black hole” sucking in funds. An appreciating dollar also undermines the corporate credit, financial environment and export of emerging market economies. More emerging and developed economies joined the race for currency depreciation to maintain their market share, an omen for trade and currency frictions. The plunge of dollar-denominated commodity prices slashed the fiscal revenue of resources-exporting developing economies but ballooned their sovereign debts, which aggravated imported deflationary risks worldwide. A stronger dollar is more likely to trigger debt or financial crises in emerging market economies. A review of history shows that whenever the dollar was strong, emerging market economies would run into some kind of trouble. Between 1993 and 2001 when the dollar surged: 1995 witnessed a financial crisis in Mexico; debt crisis broke out in Southeast Asia in 1997; Brazil experienced financial crisis in 1999; and Argentina was hit by a debt crisis in 2000.
Some Thoughts on the Federal Reserve’s
Monetary Policy Change
Henry Kissinger famously said, “who controls the food supply controls the people; who controls the energy can control whole continents; who controls money can control the world.” Indeed, money and finance lies at the core of the economy and underpins social stability. As the renowned economist John Maynard Keynes put it, “there is no subtler, no surer means of overturning the existing basis of society than to debauch the currency.” Past experience shows that systemic financial risks are much higher in a post-crisis era. As economies are highly interconnected, the Federal Reserve’s tightening of monetary policy will inevitably affect China’s financial market. It is therefore important to take precautions against potential risks or even crises and minimize its negative spillover effect on China’s economy and financial market.
1. QE by some central banks in advanced economies is unconventional or extreme monetary policy. In China, no such policy is necessary as there is still room for interest rate lowering and Required Reserve Ratio (RRR) cut, and inflation is also manageable. Conventional monetary tools would suffice. In that sense, “the Chinese version of QE” is a misnomer, as China’s interest rate lowering and RRR cut are fundamentally different from the unconventional QE of the US, Japan and some European countries. Monetary policies are only supplementary. What's important is to have structural reforms of the economy, increase investment efficiency and boost market vitality so that more jobs can be created, inadequate demand and deflationary pressure can be offset and trend growth expectations can be strengthened.
2. When monetary policy is loose and interest rate is low in the US, dollar assets flow outward to seek high-returns investments, pumping up liquidity worldwide and inflicting asset bubbles and foreign debt expansion on other countries. When the opposite happens, dollar assets flow back to the US, tightening liquidity worldwide and causing currency devaluation, capital flight, foreign exchange contraction, rising foreign debt risks, turbulence in the stock and debt markets and economic slowdown or even recession in other countries. China has more foreign exchange reserve than any other country and dollar assets take up the lion share. With the dollar’s appreciation, China’s reserve gained higher purchasing power and returns but due to some other factors, the reserve is dwindling on the whole. China needs to be thrifty and prudent in managing the reserve and regulate the buying of foreign exchange by institutional investors and individuals so that there will be sufficient foreign exchange reserve to cope with potential risks. As dollar assets are flowing back to the US, China needs to get a handle on the following three questions: first, with the Federal Reserve’s QE and ultra low interest rate, how much capital flowed to China since 2008? Second, based on a reasonable assessment of the range and speed of America’s interest rate rise, roughly how much capital will flow from China back to the US? Third, how will the America’s tightening of monetary policy affect asset prices and allocation in China? Only with a fair assessment of reality can one take pertinent measures.
3. Appropriate capital control is needed to prevent massive or even panic capital flight. In the meantime, China needs to ease access for foreign capital and further improve investment environment to retain and attract more foreign capital. With its vast market, China remains a magnet for foreign investors, but foreign capital needs to be utilized much more efficiently. China also needs to make more foreign direct investment, either through the government or corporate channel, so that it can reap returns from not only labor but also capital. While fostering a better investment environment domestically, China should also urge developed countries to do their share and not set too many bars for Chinese business investment. In addition, negotiations on bilateral investment treaties, investment and trade treaties and tax treaties should also be expedited.
4. As the People’s Bank of China (PBOC) lowers interest rate and the Federal Reserve raises rate, the interest margin between China and the US is narrowing, and it is important that China keeps deposit interest rate slightly higher than the federal funds rate. The PBOC needs to be extremely cautious in further lowering interest rate, as doing so would only worsen capital outflow. Research shows time again that the key driver for investment is economic growth or growth expectations while interest rate only plays an auxiliary role. The ECB and the BOJ, by turning interest rate negative, intends to lower corporate financing cost, drive up corporate investment, and devalue their currencies to boost export. But the cost of negative interest rate is also apparent: banks profited much less or even suffered loss; pension investment returns dropped; households began to stash cash instead of depositing in the bank; and deflationary pressure went up. Given such conundrum, in countries that adopt negative interest rate, there are also voices against such a practice. China has plenty of policy tools at its disposal. It has not only monetary policy tools but also fiscal tools and structural reform measures, so there is no need for the PBOC to join the “zero or negative interest rate” club. If further relaxing of monetary policy is needed, continued cut of RRR is an option. Ultimately, the PBOC needs to make sure that monetary policy can be effectively translated into the real economy and that capital can flow from the financial system to the real economy smoothly to avoid swelling up of the virtual economy.
5. The dollar has been strong since there are expectations of interest rate rise, and the RMB’s exchange rate with other currencies, such as the euro, the Japanese yen, the Korean won and Australian dollar went up disproportionately, denting China’s export to Europe, Japan and emerging economies. The Chinese economy is still amid restructuring with declining investment returns, slowdown in export growth and daunting tasks in reducing inventory and overcapacity. So there is no basis for continued appreciation of the RMB. Since the exchange rate reform in 2005, the RMB has appreciated by over 35% against the dollar. The IMF also recognized that the RMB is close to fair value and no longer deemed it as undervalued. Still, some keep pressing for continued appreciation of the RMB indicating that the RMB is undervalued. In this context, “the RMB is undervalued” is nothing but a political tool for protectionist trade policies. For some time to come, the RMB will continue to face pressure for devaluation both from within and outside China, but the PBOC is capable of anchoring expectations for RMB depreciation and maintaining confidence in the financial market. At the G20 finance ministers and central bank governors meeting in Shanghai earlier this year, members warned against competitive currency devaluations. China will not engage in this practice, nor is there any basis for the RMB to devalue sharply or consistently. The main problem with international trade is lack of demand, so devaluing currency to boost export won’t go very far in solving the problem. Major economies need to coordinate their monetary policies instead of “going it alone”. They all need to reduce inventory of goods and expand domestic demand instead of simply “welcoming or asking” China to do the heavy lifting while imposing various protectionist measures on Chinese goods.
6. China’s economic slowdown is a natural result of growth model shift, which is different from what advanced economies experienced as a result of their monetary policies. China needs to adopt a prudent and step-by-step approach in its financial reform. As the fourth most-used currency for payments, the yuan is increasingly a global major currency and its inclusion in the IMF SDR currency basket is only a natural development. By including the yuan in its SDR basket, the IMF is recognizing the RMB’s rising international standing. More countries will choose the yuan either in payments or foreign exchange reserves. Again, in advancing the internationalization of the yuan, the safest and most effective approach remains gradual and incremental steps. What has happened shows time and again that turbulences in the financial sector and the economy, if left unchecked, will eventually transmit to the entire society. China’s financial sector is not that sophisticated and latent regional and systemic risks must be forestalled. The irrational surge and subsequent plunge in the stock market not only threatened capital market stability but also tarnished China’s image. While further opening up its capital account, China also needs to be particularly cautious. In the financial sector, the government’s bottom line is to prevent the spread of regional and systemic risks while the central bank’s bottom line is to forestall systemic risks on the ground. When the two bottom lines are kept, financial turmoil can be avoided.
7. From ending asset purchase programs to generating expectations of interest rate rise and to actually starting to raise rate, every move of the Federal Reserve has some effect on the devaluation of emerging countries’ currencies, cross-border capital flow and decrease in their foreign exchange reserve. But the effect was somewhat muted by the following factors: the Fed’s raising rate is largely within expectations of the market and preparations, both psychologically and concretely, are already in place; the policy change from extreme accommodative to accommodative and then to a prolonged period of interest rate rise gave the market enough time to adapt to the shift, which mitigated negative spillover effect; central banks in Japan and Europe maintained ample liquidity. With expectations of continued interest rate rise by the Federal Reserve, more countries began to adopt easy monetary policies and such a binge of accommodative monetary policies offsets the Federal Reserve’s tightening of monetary policy. Since the Asian financial crisis, emerging markets’ foreign debt is expanding but compared with advanced economies, it is still small. They also have sufficient foreign exchange and manageable inflation. On the whole, emerging market economies have more fiscal and monetary policy tools to drive economic growth and are more resilient to the Federal Reserve’s policy shifts. The BRICS New Development Bank and Contingency Reserve Arrangement instituted under the Fortaleza Agreement will help relevant countries to offset short-term liquidity deficiency. The Chinese economy remains strong and with supply-side structural reform, is able to maintain a 6.5% to 7% growth rate in the next five years, benefiting other countries’ economic development and contributing to world economic growth in the meantime.
That said, emerging market economies will inevitably experience capital outflows, economic slowdown, currency depreciation and financial market turbulence as a result of the Federal Reserve’s monetary policy change. As risks of global financial market turmoil increase, emerging market economies need to follow closely international capital flow and policy change of the Federal Reserve. They also need to step up their own financial regulation and take measures to restore normal capital flow and avoid potential risks. Since capital eschews no profit, after some short-term pain, the trend of capital outflow will subside.
The Institute of International Finance predicted that the net capital outflow from emerging markets would be 448 billion dollars in 2016, much lower than the 735 billion dollars last year. As emerging market economies turned for the better, capital will naturally flow back. It is important that emerging market economies maintain their composure and not be overly pessimistic. What they need is more cohesion and confidence and be fully prepared against systemic financial risks.