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Which will mess up the most – Fed, BOJ or PBOC? – Asia Times


Anyone hating their job at the moment should spare a thought for Federal Reserve head Jerome Powell. In real time, investors can observe the extent to which Chairman Powell is confused about the direction of US interest rates.

Traders have stopped laughing at former Treasury Secretary Lawrence Summers’ contention the Fed’s next step will be to tighten, not ease. There’s little humor to be found in the Fed’s dilemma as inflation gyrates, the dollar soars and US electioneering descends into chaos.

Loads of prominent economists still think Summers is dreaming. Among them is Mark Zandi, chief economist at Moody’s Analytics.

“The Federal Reserve should cut interest rates – now,” Zandi argues. “The central bank’s current higher-for-longer interest rate strategy – steadfastly holding the federal funds rate thats directly controlled by the Fed at a high 5.5% – threatens to undermine the economy.”

Bill Dudley, former president of the Fed Bank of New York, thinks that would be a mistake. “Perhaps the Fed’s mantra, instead of ‘higher for longer,’ should be ‘higher indefinitely’ until inflation moves more convincingly in the desired direction,” Dudley wrote on Bloomberg.

The Fed isn’t the only central bank on the verge of what could be a serious policy mistake. The Bank of Japan and People’s Bank of China also may have some serious explaining to do a year from now for errors committed today.

The BOJ, for example, has almost certainly lost its window to end quantitative easing and normalize interest rates. Since taking the helm in April 2023, BOJ Governor Kazuo Ueda has passed up every opportunity to pivot toward a less accommodative policy.

Now, as Japan’s economy contracts – by 2.9% in the first quarter year on year – and inflation outpaces wage growth, it’s an open question whether any hike rates will come in 2024.

As the BOJ dithers, the yen is extending its decline – down 15% so far this year – in ways that could upend world markets. It might cause other top Asian economies to depreciate exchange rates. And it could put Asia in an uncomfortable spotlight ahead of the US election in November.

The BOJ could conceivably mess up in both directions. Tapping the brakes too soon could send the economy into a deeper recession and roil markets as the yen surges. Act too slowly and Japan slides deeper into the QE quicksand, making it even harder to exit.

The PBOC faces a daunting balancing act all its own. As Asia’s biggest economy slows, Governor Pan Gongsheng has been slow to lower borrowing costs. Many economists worry this caution is at odds with concerns about slowing economic growth.

In June, for example, mainland services activity grew at the slowest pace in eight months. The Caixin China services purchasing managers’ barometer came in at a weaker-than-expected 51.2 versus 54 in May.

Such data add to worries that healthy export gains aren’t translating into stronger domestic demand. Deflationary pressures remain a concern as China’s property crisis continues to weigh on growth despite government efforts to stabilize the situation.

“The growth momentum weakened compared to May,” says economist Wang Zhe at Caixin Insight Group. “The market was concerned about downward pressure on the economy.”

One reason Pan has been reluctant to slash rates is President Xi Jinping’s desire to avoid rewarding bad lending decisions or re-inflating asset bubbles. Xi’s Communist Party indeed allowed for bursts of stimulus. Still, the PBOC has been far less assertive than during previous slowdowns.

What’s different this time is deflation. As China’s property crisis deepens and its overcapacity woes intensify, many economists worry authorities risk letting this weak-price dynamic take on a life of its own. Xi’s party loathes the Japan comparisons so often leveled Beijing’s way.

People’s Bank of China Governor Pan Gongsheng faces a deflation dilemma. Image: Twitter Screengrab

Of course, fears about Chinese overcapacity could be overdone. Many economists counter that Chinese exports are winning right now because of production gains and innovative manufacturing techniques, not unfair trade practices.

Yet it’s the US Fed that may be most poised to make a major policy blunder.

In its extreme focus on inflation, the Powell-led Fed risks ignoring dislocations in credit markets. Not of the 2008 Lehman Brothers crisis variety but of a magnitude the Fed’s “higher for longer” yield policy may exacerbate.

Granted, economic conditions haven’t gone to plan as employment growth and wages outpace even the most optimistic forecasts. In May, consumer prices grew at a 2.6% annual rate. Though coming down toward the Fed’s 2% target, policymakers aren’t ready to declare victory.

“We just want to understand that the levels that we’re seeing are a true reading of underlying inflation,” Powell said Tuesday (July 2).

Last week, Mary Daly, president of the San Francisco Fed, cautioned it’s “hard to know if we are truly on track to sustainable price stability.”

Trouble is, the Fed could be siding with the wrong half of the trade-off it confronts. Many of the upward pressures on costs are coming from the supply side, post-Covid-19 pandemic. Such trends are better addressed via government moves to increase productivity and domestic capacity, not tighter credit.

While the Fed decides on a way forward, the US dollar is surging in ways that are complicating Asia’s year and producing credit strains in the US commercial property sector. In the wake of Covid, and the work-from-home boom it unleashed, empty skyscrapers seem sure to be America’s next financial reckoning.

Medium-size banks, meanwhile, are still reeling from the Fed’s failure to cut rates. Back in January, Powell’s team was seen easing between five and seven times in 2024. Now, some fear the higher-yield era is poised to be as indefinite as Japan’s zero-rate period.

The speed with which the Silicon Valley Bank blowup in early 2023 shook global markets demonstrates the risks posed by high yields. That goes, too, for undermining the economy.

Many are taking a wait-and-see approach. “When you have economic growth at a pace under 2%, that can be considered ‘stall speed,’” says strategist Rob Haworth at US Bank Wealth Management. “But we’re still seeing solid consumer activity, which has been the most important factor driving the economy to this point.”

But Mohamed El-Erian, president of Queens’ College, Cambridge, argues the US is “slowing faster than most economists expect and faster than what the Fed expected.” This “excessively data-dependent” Fed team risks keeping borrowing costs “too high for too long.”

The dollar’s “wrecking ball” tendencies, meanwhile, are shaking up global markets. It’s hoovering up outsized waves of global capital, disadvantaging emerging economies in particular. Political polarization in Washington, meanwhile, doesn’t augur well for capping the dollar’s rally.

“In a divided government, there’s less ability to pass a lot of meaningful fiscal measures,” notes strategist Kamakshya Trivedi at Goldman Sachs. “It’s fair to say that for this particular election we’ll see trade policies and fiscal expansion policies being debated and potentially implemented. As a result of that, an even stronger dollar is a real possibility and a risk for the rest of the world to manage.”

US President Joe Biden’s disastrous debate performance versus rival Donald Trump further muddied the outlook. Trump’s odds of returning to the White House seem higher than ever.

“It is now clear that investors have made the Trump-stronger dollar link,” analysts at ING Bank write in a note. “This has also been our interpretation given the prospect of lower taxes, inflationary protectionism measures and greater geopolitical risks under Trump.”

Donald Trump is being linked to an even stronger, not weaker, dollar. Image: X Screengrab

Periods of extreme dollar strength don’t tend to go well for Asia’s export-reliant economies. Powerful dollar rallies of the kind the globe has seen these last few years tend to hoover up disproportionate amounts of capital, depriving Asia of badly needed investment.

The Fed’s “taper tantrum” of 2013 is one earlier reminder of this phenomenon. But the real bookend for Asia is the 1994-1995 period, the last time the Fed tightened as aggressively as it has over the last two years.

At the time, the Fed doubled short-term interest rates in just 12 months. The tightening set in motion Mexico’s peso crisis, the bankruptcy of Orange County, California and the demise of Wall Street securities giant Kidder, Peabody & Co.

Then came the biggest casualty of all: developing Asia. By 1997, a multi-year dollar rally and rising US yields made Asian currency pegs to the dollar impossible to maintain.

First came Thailand’s chaos-generating devaluation in July 1997. Next, Indonesia and South Korea scrapped dollar pegs. The turbulence also pushed Malaysia and the Philippines to the brink. Before long, global investors began worrying Japan and China might stumble, too.

The fear was that China might devalue, catalyzing a fresh wave of market turbulence. Luckily, Beijing didn’t – just as it hasn’t today.

Japan contributed to the drama back then when, in November 1997, Yamaichi Securities collapsed. The failure of a then-100-year-old Japan Inc icon shook global markets. Thankfully, officials in Tokyo kept the collapse from becoming a systemic shock globally.

Now, Asia faces a giant shock from the other direction. Despite the rally, global investors are losing faith in the dollar as an even bigger systemic risk – and a more immediate one.

The de-dollarization movement is gaining momentum just as the US national debt hits the $35 trillion mark. What’s more, Washington’s debt burden is headed to $50 trillion by 2034, according to the Congressional Budget Office.

The dollar’s stability was shaken anew in mid-November when Moody’s Investors Service threatened to downgrade the US. That would mean the loss of Washington’s last AAA rating, which would likely send US 10-year yields skyrocketing.

Is the Fed making an epic mistake? Only time will tell. But it’s just one of several top central banks whose mistakes could shake the global financial system in ways few appear to see coming.

Follow William Pesek on X at @WilliamPesek



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