Now, Powell either has to keep hiking or risk pausing and being accused of bowing to political pressure from the White House.
Think on that.
That’s from “‘We Are Raising Rates – Really?’ Trump Again Attacks The Fed, Accuses Europe, China Of ‘Manipulation’”, and it’s consistent with the assessment of pretty much anyone you care to ask about Donald Trump’s ill-advised decision to weigh in on the relative merits of Fed hikes during war time.
By “war time”, I mean the trade war which, thank’s to Trump’s explicit acknowledgement of the extent to which the policy divergence between the Fed and the PBoC is helping China weather the tariff storm, has now become squarely focused on FX.
The problem here is the same as it ever was: Trump’s policies have a demonstrable tendency to trip over themselves for any number of reasons, not the least of which is that he’s trying to do too many things at once. This is apparent, for instance, in his efforts to turn the screws on Iran while simultaneously attempting to push oil prices lower.
When it comes to the policy divergence between the Fed and the PBoC, China is basically just letting the Fed’s hawkishness do all the work. Sure, they’re leaning on the dizzying array of policy levers at their disposal, but the anchor is Fed hikes. If the Fed paused or cut rates, China would have to try a lot harder when it comes to encouraging yuan weakness.
Of course the reason the Fed has to be so hawkish in the first place is because Trump’s fiscal policies amount to piling stimulus atop a late-cycle dynamic, increasing the risk of inflation. To make matters worse, tariffs have the potential to drive up domestic prices too. The Fed has to guard against that, which means if Trump is looking for someone to “blame” for Fed hikes and thereby for the policy divergence with China that’s pushing the yuan weaker, well then “mirror, mirror on the wall, who’s the most stable genius of them all?“
Previously, the Fed retained the option to take a pause or to cut rates in the event the dollar strength and/or the trade tensions created enough turmoil in emerging markets to spillover into developed market assets and tighten financial conditions beyond what the Fed is seeking to accomplish. Now, as alluded to in the excerpted passages here at the outset, that option is limited by the bad optics. That is, if Jerome Powell cuts rates or otherwise leans dovish, he risks being castigated for politicizing the Fed.
That means Trump has just inadvertently put himself behind the eight ball. Consider this, from a Deutsche Bank note dated Thursday:
We can analyze the impact of RMB devaluation in terms of financial conditions and the impact on the Fed stance. As was the case in 2015 and has held true of late, a quickly depreciating CNY would not happen in a vacuum – it would inevitably be accompanied by similar scale weakness in other EM Asia FX – as was the case in 2015 and has been the case for the bulk of this year. Ultimately, it implies that the Fed would be justified in a softer stance than otherwise.
In the below table, we illustrate the impact on financial conditions from dollar strength implied by different USDCNY levels and rates of deceleration. For the sake of our estimates, we assume similar scale depreciation across Asia EM currencies when calculating the impact to the trade weighted dollar. A lower value of FCI is consistent with tighter conditions, which are scaled to mean zero and standard deviation of one – a move to USDCNY of 8 in 3 months’ time would imply more than half a standard deviation tightening in US financial conditions. Historically, tighter financial conditions in the US have been well correlated with weakness in EM equities, shown in the chart on the right.
You could complicate this if you wanted to, but it’s rather straightforward. If the PBoC continues to let the yuan weaken or, worse, actively depreciates it, they can engineer a spillover into the wider EM complex and ultimately, catalyze a tightening of developed market financial conditions.
Previously (i.e., prior to Thursday), this wasn’t that big of a deal, because the Fed could pause, lean dovish or, in an extreme scenario, cut rates, in an effort to ameliorate the situation and prevent financial conditions from tightening too much.
But now, any move along those lines would be seen by markets and by lawmakers as Jerome Powell “doing political things” (as Trump once accused Janet Yellen of doing for President Obama).
You might recall that in a followup to the bombshell interview with Joe Kernen, CNBC cited a White House official as saying that Trump is concerned about the Fed hiking twice more this year.
As Deutsche Bank goes on to write in the same note, it’s possible to “estimate the equivalent Fed easing that would typically be associated with the various shocks to financial conditions under the different CNY scenarios”. By that they mean the scenarios shown in the table above. Here’s more:
The change in the Fed stance – which we define as the 12-month change in spread between the real funds rate and r-star – tends to co-move with financial conditions, with Fed stance getting tighter as conditions get easier, and easier as conditions get tighter.
Needless to say, it seems highly unlikely that, in light of Trump’s comments to CNBC on Thursday and especially in light of his tweets on Friday, Jerome Powell would be able to get away with two rate cuts in the event the yuan weakened through 8.00 without being accused of handing over the keys to the Eccles building to Donald Trump.
China has undoubtedly already figured this out, which means they’re now holding a hand that is infinitely stronger than it was just four days ago. Now, they can force Jerome Powell to choose between sitting idly by as a plunging yuan ripples through markets on the way to tightening U.S. financial conditions, or resorting to what would amount to emergency rate cuts that would permanently damage his reputation and undermine his credibility less than six months into his tenure as Fed chair.
The “art of the deal” strikes again.