Illustration: Peter C. Espina/GT
Market expectations for an interest rate hike by the US Federal Reserve in March rose sharply after Fed policymakers made comments about backing a rate increase.
Nevertheless, with the odds soaring for a March rate hike, the US dollar index, which measures the greenback against a basket of currencies, still witnessed volatility despite a generally upward trend in the past week. Usually the dollar tends to rise when interest rates go higher, which indicates higher returns for dollar-denominated deposits. But so far the dollar index hasn't performed as strong as expected assuming an earlier-than-expected interest-rate hike in March.
The Fed's timing for its next rate hike is confusing. Although the Fed forecast three interest rate hikes this year, its credibility has long been questioned and it is under no obligation or pressure to push ahead with an increase so early.
Fed Chair Janet Yellen has explained that the slower-than-anticipated increase in the federal funds rate target was because most Fed policymakers believe the neutral federal funds rate - defined as an interest rate that is neither expansionary nor contractionary, and that allows the economy to operate with full employment and low inflation - is quite low by historical standards, due to factors like slow productivity growth and an aging population. Certainly the depressing effects of such long-term factors will not diminish in the short run. Therefore, it seems that the Fed's near-certain rate hike is being driven by inflation.
However, US inflation figures are not strong enough to justify an earlier-than-expected interest rate hike, which is why market expectations for a March rate increase remained low before Fed executives signaled it. Meanwhile, in the labor market, both the average hourly earnings and employment cost index have been relatively weak, far from facilitating a virtuous circle for the US economy - that is, strong demand helps fuel a rise in production, which leads to strong employment and wage hikes, finally resulting in prices increase. In other words, the current pickup in US inflation is due in large part to the recovering energy prices and increased import prices, a sign that the US economy still lacks sustained momentum and remains stagnant.
Then why did the Fed switch to hawkish talk when it obviously did not have to do so? I tend to believe that the Fed is trying to bluff the White House.
US President Donald Trump has made some eye-catching, controversial claims about his economic policies. For example, Trump once promised to shrink the country's trade deficit through a trade war, but most of the middle class in the US rely on inexpensive and high-quality imported goods. If Trump blocks imports, the high labor costs in the local market will only lead to soaring product prices and stalled consumption. Also, Trump plans to increase fiscal stimulus and infrastructure spending to create jobs, but a lack of skilled workers in the country could easily cause the plan to fail. If Trump really wants to revitalize the US manufacturing industry, a sharp one-time depreciation in its currency may help achieve the goal, but it would make the consumption-led economy suffer significantly in the short term.
Trump's questionable economic policies, including trade war, fiscal stimulus, dollar depreciation and loosening financial regulations, will likely push inflation levels to grow faster than expected, which is why the Fed had to signal a March rate hike to reflect risks and warn the White House. Market expectations for an early interest rate hike is not a good signal in the sense that economic uncertainties are growing. Therefore, whether the Fed raises interest rates in March or not, investors should be cautious toward buying into dollar assets in the short term.
As for China, the volatility in the dollar will slightly ease the depreciation pressure on the yuan in the near term. In addition, the tightened financing in the domestic market will promote enterprises seeking financing overseas, pointing to relatively stable foreign exchange reserves.
In the near future, the international foreign exchange market will mainly focus on the political risks in Europe, with two rounds of voting for the French presidential election scheduled in April and May.
The author is a senior analyst at China Merchants Bank. firstname.lastname@example.org