Following the 2008 subprime mortgage crisis, the importance of both base interest rates and currency exchange rates increased significantly. People have come to expect the Fed to resolve all economic issues using monetary policy solutions. Many investors now base their investment decisions primarily on the Fed and other central bank policies. While there are fiscal tools in the hands of the government that can spur real economic growth, their efforts to use them go largely ignored. People look to central banks for all the answers instead. The mindset of seeing these banks as the main vehicle for supporting the economy characterizes China, Europe and the US alike.
We can trace back the trend’s origins to the former Fed Chair Ben Bernanke. He took an uncharacteristically proactive role during the Bush administration. Believing that the administration struggled for economic solutions, he began lowering base interest rates on the dollar. The goal was to increase liquidity. This program later became known as Quantitative Easing. His actions at the time were widely considered extreme and many worried about the potential risk of hyperinflation. In the end, however, the results vindicated his efforts.
Seeing his success central banks from other countries began emulating his policies and enacted their own easing programs. Due to the delay, most countries were a few steps behind the US in terms of recovering from the crisis. If you asked anyone whether they remember what policies the Chinese and European governments used to mitigate the crisis, you would get very few answers. Nobody remembers because they were largely ineffectual.
Exchange Rates and Monetary Policy
Over the past decade, low interest rates and constant monetary stimulus have become the cornerstones of the modern economy. Free money is the basis of rising stocks and near zero interest rates are a requirement of economic growth. It needs to be said that this type of dependency is a form of life support. Knowing that, The Fed has been making an active effort to wane the US economy off of it.Even more so once they saw that it can stand on its own feet. Unfortunately the current trade dispute with China threw a wrench in the works. The initial sentiment was that it would be a short game of tit for tat before they finally sit down to negotiate. Although the tariffs have been put on hold and both parties promised to work together, there’s still no final agreement in sight.
The US made the opening move in this game of economic chess. The latest maneuver of placing a 10% tariff on an additional 300 billion dollars worth of Chinese products aimed to put China on the defensive. Their alleged reaction was to respond to a fiscal measure with monetary policy by devaluing the yuan. Chinese bankers haven’t officially confirmed that’s what actually happened, however, when you take a look at the USDCNY rates it seems rather convenient.
Just to be safe, let’s rely on Credit Suisse analysts to confirm our suspicions. Based on their calculations the devaluation is a suitable counter to the consequences of the tariffs. At a USDCNY rate of around 7.0, 70% of the effects of the initial 25% tariffs on 250 billion dollars worth of goods and the second set of 10% tariffs on an additional 300 billion dollars of products would be neutralized.
A Competition of Tariffs and Exchange Rates
Washington is aware of these stats as well. The administration openly accused China of manipulating the yuan’s exchange rate. Doing so would actually infringe on a number of international agreements. Peking insists that there was no foul play and their actions were a legitimate response to the one-sided US tariffs. The way both parties point fingers at each other is a distraction at best, until everyone eventually accepts China’s monetary policies the same way they accepted the US tariffs.
Over the past few years we’ve seen the influence of international trade organizations decline. So has the importance of multilateral trade agreements, which played some role in the mutual loss of trust between market participants. It’s natural to assume that a market that lacks confidence undermines investor confidence and the stock market did take a hit, but not nearly as much as you’d expect. Even without trust, the economy remains stable. In-part this can be attributed to how The Fed continues increasing liquidity and raising interest rates. There’s no doubt that its policies distort the market. That said, given the current political and economic climate they have no choice but to keep going, whether they want to or not.