September 2015
Schroders
Talking Point
China shakes the Fed
Keith Wade, Chief Economist
No change in interest rates and a flatter profile for future rate rises signals a step in a more dovish direction by
the Federal Reserve (Fed). External factors tipped the balance with Federal Reserve chair Janet Yellen
referencing China concerns during her press conference. Lower commodity prices and a strong dollar are
weighing on consumer prices, giving the US central bank more time to keep rates at close to zero. The Fed is
watching carefully for signs of a hard landing in China, which would exacerbate deflationary pressure in the
world economy.
Certainly these developments will keep inflation low in the near term, but we would still see domestic price
pressure building through the labour market. The unemployment rate has now reached its equilibrium on most
estimates and on current trends will fall further in the coming months. It is true that wages have not accelerated
as yet, but it is only likely to be a matter of time before we see wage costs picking up.
As external factors are outweighing domestic, it could be argued that the outlook for the Fed now depends on
the outlook for China. In our view, China may get a boost from fiscal support in the coming months, but the
underlying picture is one of an economy where growth is grinding lower. Our indicators suggest growth will
decelerate toward 6% in 2016, as the economy faces structural headwinds from overcapacity. So no hard
landing, but no clear pick-up. Meanwhile, the economy will experience persistent deflationary pressure and
markets will continue to debate the need for more policy action from the authorities, including a potential
devaluation of the Chinese yuan.
Against this backdrop we will need to see strong evidence of rising wages before the Fed will be confident that
inflation is headed back to 2%. This could take months: if we focus on the Employment Cost Index, seen as the
best measure of wage pressure in the economy, we will need to wait for the next release at the end of October,
and then probably the one after at the end of January, before being able to confidently identify the upswing in
wage costs.
Comparisons are being made with two years ago when the Fed decided not to taper following a tightening of
financial market conditions. Today is similar, but the current Fed could well wait beyond January before lift-off
with March 2016 now the more likely date.
Is the Fed now behind the curve? The risk has to be that by delaying rate moves they will stoke future inflation
and will then have to respond more aggressively. However, the current environment is reminiscent of the late
1990s when the Fed cut rates in response to emerging market turmoil, more specifically the Russia default.
Like today, there were fears of deflation as external pressures outweighed domestic. The consequence was
that US policy was kept loose; however in the Fed’s defence this did not result in a sharp pick-up in inflation.
Instead the excess liquidity fed into financial markets as investors took increasing risks and ultimately stored
up bigger problems for the banking system and the economy.
SchrodersTalking Point
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