How many captors for the Fed?

I liked the title of this article but not its content. It reflects flawed thinking. Both the content and the underlying subject of the article are extremely disappointing, to put it mildly.

I had gone through the speech by Ms. Yellen to the Economic Club of New York. She lays down all the domestic reasons as to why there should not be any deviation from the path of monetary policy that was telegraphed to the market, in the second half of 2015. Yet, she repeats the word, ‘global’ several times in the speech and devotes a paragraph to China.

Either China is blackmailing the United States into not acting on interest rates that would push the US dollar higher such that the yuan would strengthen with it too. That would not happen if China had a truly floating currency. It does not. It is keeping the currency stable against the dollar. But, it is falling against a basket of currencies. So, the Euro and the Yen are not only appreciating against the US dollar but are also appreciating against the Yuan.

Their economies are not in any position to absorb the shock. For example, check out the details of the latest Japan Tankan manufacturing survey. It is dreadful. Business conditions worsened from December and large, medium and small enterprises expect it to worsen further in June. That is true of both manufacturing and non-manufacturing sectors. Investment (capital expenditure) plans of firms of all sizes are drastically down. So much for the efficacy of negative interest rates.

So, the question is why the US is doing it. Is it being blackmailed by China or is it that, on its own, the US has deemed the China economy ‘Too Big To Fail’. In other words, does the US know more about the dire state of the Chinese economy than market equanimity suggests? We can only speculate on it but that is a strong possibility.

The problem is that the rest of the world is in no position to throw a lifeline to China. Everyone is in need of it.If the stock market in the United States crashes, the dollar will weaken far too much, putting enormous burden on European and Japanese economies. So, the stock market, notwithstanding its (yet another) de-coupling from economic fundamentals, industry fundamentals and corporate fundamentals, has to be stopped from crashing. Yet another reason to sing a dovish song. It is all about using fingers to block the holes in the dyke from becoming bigger.

As the first quarter of the New Year ended, this front-page story in FT reports that trading revenues for investment banks plunged. US stocks are within a whisker of their all-time highs. Do you get it? I don’t. Check out the rate of (net) new business formation and net new jobs in business formations. The current economic cycle has been the worst. Yet, corporate profit margins have soared. I doubt if it is either sustainable or desirable. Yet, Yellen’s speech was conspicuously silent on the risks of allowing and even encouraging the stock market to continue on its flight of fancy, with her ‘softly, softly’ monetary policy approach.

That is what Ms. Yellen has been doing in recent weeks. Ever since the Federal Reserve Open Market Committee Meeting in March, the Federal Reserve has been trying hard to downplay interest rate hike expectations for the reminder of the year. In the process, she has tied herself into knots. Check out these statements from her recent speech:

I anticipate that the overall fallout for the U.S. economy from global market developments since the start of the year will most likely be limited, although this assessment is subject to considerable uncertainty.

The shifts in these measures notwithstanding, the argument that inflation expectations have actually fallen is far from conclusive…. Taken together, these results suggest that my baseline assumption of stable expectations is still justified.

If economic conditions were to strengthen considerably more than currently expected, the FOMC could readily raise its target range for the federal funds rate to stabilize the economy. By contrast, if the expansion was to falter or if inflation was to remain stubbornly low, the FOMC would be able to provide only a modest degree of additional stimulus by cutting the federal funds rate back to near zero.

If there is little scope to provide additional stimulus to the economy with rates at 0.25 to 0.50%, the fault, dear Yellen, lies with the Federal Reserve. While it is still watching hourly earnings for signs of acceleration, for its impact on inflation and for the consequent need to respond with higher interest rates, a similar state of vigilance on excessive profit margins relative to the average has been conspicuously absent in the monetary policy stance of the Federal Reserve.

Corporate profit margins in the United States had reached levels never seen since 1950 (10.2% in Q4). They had exceeded the level seen even during the global synchronised boom seen in the new millennium (10.5% in 2012Q1 vs. 9.6% in 2006Q2).

Such unusual buoyancy in corporate profits was not backed up by economic growth, job creation, wage growth, formation of new businesses and confidence among small businesses. The only explanation is that the cost of capital was unusually low. Yet, the Federal Reserve did not act between 2009 and 2015. Had it done so, it would not have to worry about being able to provide only a modest degree of additional stimulus.

The Federal Reserve has sided with capital and that too the worst form of capital – financial capital – against labour, in the guise of supporting labour and employment generation. In the end, it would benefit neither capital nor labour, when asset prices crash as they eventually and inevitably do.

In his characteristically understated way, Mohamed El-Erian wrote in Bloomberg:

Financial markets that feel empowered and enabled to force the Fed’s hand — regardless of the underlying economic and corporate fundamentals.

This was one of the three forces holding the Federal Reserve hostage, according to him. The other two being international developments and non-responsive politicians who burden monetary policy with the responsibility to keep the global economy from collapsing.

He does not name China specifically. That is an omission. Yellen did not feel embarrassed to admit the China factor in their calculus. Financial markets meet with their comeuppance. But, who will tame China? In many ways, it is not behaving as a responsible stakeholder, globally. Ask India.


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