Why Fed Policy Mistakes Are Now Inevitable

As noted earlier on Monday evening, we’re seeing Catch-22s everywhere these days as central banks are constantly tripping over their own, previously enacted policies while trying desperately to extricate themselves from what has turned into an eight-year old experiment in Keynesian insanity.

One of the problems is that the Fed is ahead of the ECB and certainly the BoJ when it comes to normalizing. This means that as the FOMC hikes, DM policy divergence will only grow, putting further upward pressure on the dollar.

That’s fine for Europe and Japan as it makes their economies more competitive, but it puts quite a bit of pressure on the Chinese RMB. Indeed, it effectively forces Beijing into a one-way devaluation of the yuan lest it should appreciate too much against the currencies of China’s trading partners. Expectations of further weakness in the RMB exacerbate capital outflows, and that, as we’ve seen, can destabilize global markets.

Below, find some good commentary from PIMCO who explains why the “very same” rate hikes that the Fed justifies by pointing to stable financial conditions could serve to destabilize markets, prompting a dovish lean from the FOMC in a never-ending cycle where policy mistakes are inevitable at every turn.

From PIMCO:

Heightened cross-asset correlations can have economic implications as well – a key example is the interdependence between global financial conditions and the Federal Reserve’s policy path. With the U.S. unemployment rate currently at 5% and inflation expected to converge toward target over the medium term, some observers would argue that domestic conditions warrant additional hikes in the policy rate. However, this would inevitably lead to a stronger U.S. dollar against the backdrop of negative interest rates in Europe and Japan. Dollar strength versus the euro and yen would also drive up the value of the Chinese yuan, which is linked to the dollar. But unlike the U.S., China’s domestic conditions do not justify a stronger currency and in fact may not be able to cope with the accompanying drag on exports.

The reaction function of the Chinese central bank to an unwelcome currency appreciation could destabilize risk sentiment and potentially bring about disorderly U.S. dollar strength, wider credit spreads and increased likelihood of global deflation. Under such a tightening of financial conditions, the U.S. private sector would face higher borrowing costs and decreased export competitiveness, hindering the tenuous economic recovery upon which the Fed’s decision to raise rates was based. Consequently, the Fed would like to see stable financial conditions before implementing rate hikes, but those very same rate hikes could subsequently destabilize financial conditions. The correlation web is complicated and consequential for the global economy.

Advertisements

2 thoughts on “Why Fed Policy Mistakes Are Now Inevitable

  1. Trickle,trickle,trickle damned if you do screwed if you don’t. At first it doesn’t look to bad this debt thing. It is just a few points of our GDP, well a few more billions isn’t that much more we can handle it. Shit what’s another war or two, don’t worry about the dead and the cost of wounded by the way we don’t even have to put in the budget. Trickle….. “We need 600 billion by Monday or the world markets will implode”. Trickle… To be continued…..

  2. So it was all ‘Fed insanity’ which is now leading to massive risk created by the Fed? The alternative was bloodletting and upheaval, certainly profitable for some, as will be any risk ‘created’ by the Fed or other tightening central banks. However, it should have been obvious that those balance sheets would have to shrink.

Speak On It