World: Uncertainty swirls over outlook as Fed ponders next step

For Federal Reserve policymakers championing a rate increase this autumn, the pieces were falling neatly into place. Again the China-induced squall struck.

Presently as senior Fed figures gather in Jackson Hole, Wyoming, for their annual symposium, market gyrations and the potential for a sharp downturn in China, by some measures the world’s biggest economy, have put widespread expectations for a move next month on ice, and some economists are questioning whether a rise will happen in 2015 at all.

William Dudley, the New York Fed president, argued on Wednesday that the case for September had become “less compelling”, even if he was ruling nothing out. Esther George, the hawkish president of the Kansas City Fed, which is arranging the meetings, agreed that the Fed had to tread cautiously.

The problem for the Fed is the sheer uncertainty over how grave the Chinese downturn will be, and the concern that Beijing’s leadership has a much shakier handle on its markets and economy than before believed. Given market volatility, it makes additional sense to wait and see how the ruckus affects the data than to rush with a rate increase that may only add to the turmoil.

From presently on what makes the picture doubly complex is that, even as overseas developments conspire to dislodge officials’ September aspirations, the domestic US economy is looking progressively healthier, suggesting a widening gulf between the US and emerging markets.
Official increase data yesterday showed that the economy grew additional quickly than estimated in the second quarter, rising by 3.7 % — well above sub-2 % estimates of potential increase. The initial half of the year, which a few months ago appeared a write-off to the Fed, actually saw a robust expansion.

“We entered the market turbulence with momentum, and that is great,” said Diane Swonk of Mesirow Financial in Chicago. “But the turbulence reflects a new reality about China, emerging markets, and increase abroad. It’s additional shaky, less consistent. The best-case scenario is China can stabilise at a lower increase rate. That is a different paradigm from what we have known from last decade.”
US exports to China represent only 1 % of its GDP, meaning the direct impact of the Chinese economic woes looks modest at initial glance. Indeed, the slump in commodity prices triggered in part by the slowdown could deliver a fresh impetus to US households, next consumption grew additional than 3 % in four out of the five completed quarters.

But China accounted for 40 % of world increase last year, meaning the indirect effects of its problems, particularly at the same time as coupled with weakness in other emerging markets such as Brazil, could still reverberate back to the US via the dozens of nations that rely on China heavily. The prospect of stronger increase and higher rates in the US could trigger capital flight from weakening emerging markets, inclunding currency gyrations and further market instability. That could push up the dollar further, dragging on US exports and inflation.
As well, some investors fear China could liquidate holdings of US treasuries as it supports its currency, with impact on American bond markets. That concern may help explain why US yields have held up in recent days, although Roberto Perli of Cornerstone Macro argues the reason for robust yields is likely to be optimism about the US recovery.

Further muddying the US outlook is the inflation picture. While the Fed is presently on the cusp of conference the initial half of its dual mandate, which requires it to ensure maximum employment, the second half — targeting 2 % inflation — is much less certain. Market inflation expectations have dipped of late as commodity prices slump amid faltering Chinese request and generous supply.

 

With West Texas Intermediate oil prices back below $40 a barrel, there is a risk that inflation figures get knocked back again, further delaying the prospect of a return to the Fed’s 2 % target.

 

Janet Yellen, the Fed chair, skipped this year’s Jackson Hole meetings, as did the European Central Bank chief Mario Draghi, meaning attention will be focused squarely on vice-chair Stanley Fischer, who will address the conference tomorrow. He will have to give a carefully nuanced message.
Ms Yellen has gone to great lengths to convince markets that the Fed is ready to lift short-term rates this year. Acting sooner will allow the central bank to tighten gradually, she told Congress this summer. But if the Fed does not raise rates in September, officials may start to feel compelled to start opening the door to a move in 2016, given the uncertainty over whether the opportunity will come in the two meetings of the year.

That would only embolden those investors who argue that the US economy simply is not ready for higher rates.