from Follow the Money

US monetary policy: right for the US, wrong for the dollar zone?

September 10, 2007

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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The US economy is faltering, at least a bit, on the back of the troubled housing market.   Uncertainty surrounding the value of debts backed by subprime US mortgages has created more than a bit of turbulence in global markets.   And particularly after the jobs data, the market expects the Fed to cut – 

Indeed, there is a meaningful possibility that the Fed’s widely expected cut in September will be followed by a series of additional rate cuts.   Dr. Hamilton has a wonderful summary of the current debate over the timing and pace of US rate cuts.

The dollar is – no surprise – once again weak relative to the other major currencies.  At least part of the dollar’s August rally seems – at least to me – to have been tied to deleveraging (including deleveraging by European banks) rather than safe haven flows.  Selling rubles and Asian equities to pay back borrowed dollars isn’t quite the same as seeking out the dollar because you expect it to rally in times of stress.

No matter.  The US economy could benefit from a boost from the export side as it works through the excesses that emerged out of the housing boom over the past few years. 

But the Fed doesn’t just set monetary policy for the US.  It also sets monetary policy for all the countries that are pegged to the dollar (The Gulf) and heavily influences the monetary policy options available to countries that manage their currencies primarily against the dollar (China).   And while a weaker dollar and lower rates are precisely what the US needs at this stake in its economic cycle, they aren’t obviously what the rest of the dollar zone needs.

Take the Gulf.   Oil prices are still high.  The Gulf countries would rater they stay high as well -- they don't want to increase production as the global economy slows and repeat their mistake of the late 1990s. 

Spending and investment are still adjusting upward.   Kuwait, for example, spent less than expected in its fiscal 2006 because it couldn’t spend all the money allocated for capital improvement in the calendar year.  But that spending will no doubt take place in 2007.  A small fall in the oil price shouldn’t change this much: spending and investment decisions made over the past few years are now being implemented, and in the worst case scenario, the Gulf can finance its currently planned investment out of its existing assets rather than out its oil export revenue.   

The result of higher spending and investment and a weaker currency: high rates of domestic inflation.  Real rates are already negative in some Gulf states, and very low in others.   

The last thing the Gulf needs is lower nominal rates and weaker dollar.

China is another case.    It is also booming.   CPI inflation is now rather high.   Real rates are now negative, certainly for deposits and increasingly for loans.    The PBoC generally has been tightening monetary policy – raising reserve requirements, raising China’s policy rates – not loosening monetary policy.    China hasn’t exactly hesitated to grow on the back of strong net exports that stem in part from the RMB weakness against a broad range of currencies.  But at this stage in its cycle, it also isn’t clear that even export-addicted China wants an even weaker RMB. 

It is possible that the inconsistency between the monetary policy China needs and the monetary policy it will tend import from the US so long as it manages its exchange rate primarily against the dollar will be resolved by the “recoupling” of China’s economic cycle to that of the US.   China shrugged off the US slowdown over the past year – in part because booming exports to commodity exporting regions and Europe more than offsetting a slowdown in the pace of growth in China’s exports to the US.    However, if the US slump broadens – and particularly if US consumption growth falters, really pulling down the growth in Chinese exports to the US – China may not be as lucky.

On the other hand, if China’s economy has by now developed a strong momentum of its own – or if China can continue to explain the RMB’s weakness against the Europe to grow on the back of European demand (and the oil spending and investment boom) – China’s economy cycle may not follow that of the US. 

No doubt that is the scenario China prefers.   

But a booming China and slumping US does create a challenge for the PBoC, as the PBoC will likely be tightening (or on hold) as the Fed is cutting. 

It would be interesting, intellectually speaking, to see if China’s capital controls – which Ma and McCauley of the BIS believe still are effective enough to provide China with a degree of monetary policy autonomy (hat tip, Menzie Chinn) – still work well enough  to allow the PBoC to push the interest rate on Chinese bank deposit rates above the US fed funds rates ….  

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