The Complexity of the U.S. Interest Rate Hike and the RMB Exchange Rate

The Federal Open Market Committee (FOMC) had recently voted to lift its key rate by 50 basis points, raising the federal funds rate to a range of 0.75% to 1%. The FOMC also decided to shrink its balance sheet by USD 47.5 billion a month starting June 1. The FOMC would gradually increase the cap on shrinking up to USD 95 billion a month over three months. This marks the official entry of the U.S. into the rate hike cycle. Fed Chair, Jerome Powell, has largely ruled out a 75-basis-point rate hike in the near term, reaching a consensus within the Fed that a 50-basis-point rate hike would take place in the next few meetings.

The combination of U.S. interest rate hikes and a shrinking balance sheet spooked Wall Street. On May 11, local time in the United States, the three major U.S. stock indexes closed down across the board. The Dow Jones Industrial Average fell 1.02%, the Nasdaq 100 Index down 3.18%, and the S&P 500 Index dropped 1.65%. The technology sector led the decline, with Apple tumbling 5.18%, and USD 129.6 billion in market value evaporated overnight. The Dow Jones closed at 31,834 on May 11, having fallen to a 15-month low.

Figure 1: The Dow Jones Industrial Average fell to a 15-month low

Source: Sina Finance

It is unclear what the Fed intends to do with its shrinking balance sheet while significantly raising interest rates.

Curbing inflation seems to be the most indisputable explanation. Data released by the U.S. Department of Labor on May 11 shows that the U.S. consumer price index (CPI) rose 0.3% month-on-month in April and 8.3% year-on-year. The consumer price index in the United States is still at record highs, indicating that the country is experiencing persistent inflationary pressures. By raising interest rates and shrinking balance sheets, a certain amount of capital needed would be compressed and frozen, slowing production activity and thus lowering inflation. If that is the intended target, then it is certainly within the goals of the Biden administration and the Democratic Party. ANBOUND sees Powell as a political figure appointed by President Donald Trump, but Biden kept him because of his willingness to cooperate.

The concern is whether Powell’s policy decision is working. It appears that it may not be the case.

The logic is that if inflation sends the economy into a downward spiral, politics will suffer as well. If the Fed makes good use of interest rates, it will boost consumer confidence. Inflation would be effectively controlled by the subsequent slowing of industrial expansion. However, social dissatisfaction will increase due to loss of income as a result of a rise in unemployment. To combat inflation, the Fed has begun aggressively raising interest rates. The market is apprehensive that this could trigger a recession and is linked to the stronger correction in U.S. stocks recently.

As a result, given the current political situation, interest rates may not be the best tool for adjustment, leaving Powell in a bind. If Powell insists on a significant rate cut to combat inflation, neither him nor Biden will benefit, but the Republican Party will.

So, does the U.S. have better policy tools?

There is no accurate answer to this question. ANBOUND’s founder Chan Kung believes that in general, the exchange rate tool is more likely to achieve policy goals.

A stronger U.S. dollar would lower the exchange rates of other countries, making U.S. imports cheaper. The resulting low prices would indirectly control inflation as well.

Figure 2: U.S. Dollar Index continues to rise

Source: Sina Finance

This exchange rate strategy is equivalent to exporting inflation, but it is better than raising interest rates. While substantial interest rate hikes will help control inflation, this could somehow inhibit the restoration of the U.S. economy. However, if the United States pushes for a stronger dollar, dollar-denominated assets in the market could produce safer results.

Overall, Chan Kung believes that the Fed’s decision to raise interest rates is complicated and that this complexity is consistent with the current round of inflation. This is not only a currency issue, but also involves supply chain disruption, global industrial restructuring, geopolitical fragmentation and conflict, and the stagnation of globalization. Only one thing appears to be certain: relying solely on the Fed to raise interest rates and reduce its balance sheet to control inflation may not be effective. If the rate hike is not implemented properly, it could plunge the U.S. stock market and economy into crisis.

The United States’ use of exchange rate tools to boost the dollar necessitates China’s attention. This force will not only have an immediate impact on the pattern of China’s exchange rate, but it may also result in an outflow of Chinese capital. Since mid-April, the exchange rate of the RMB and the U.S. dollar has fallen rapidly. As of May 12, China’s offshore exchange rate has fallen below the 6.8 mark, hitting a one-and-a-half-year low. The exchange rate is America’s most beneficial tool to ease inflation, but the RMB will take a hit.

Final analysis conclusion:

The U.S. has already started raising interest rates to curb inflation. However, the slump in U.S. stocks reveals that excessive interest rate hikes could hit U.S. capital markets and economic growth. The exchange rate appears to be more favorable to the U.S. than the interest rate tool. Nonetheless, that would put pressure on China’s exchange rate and could drive capital out of the country.

Writer by He Jun
Partner, Director of China Macro-Economic Research Team and Senior Researcher. His research field covers China’s macro-economy, energy industry and public policy.

For more information:
Website: http://www.anbound.my
Twitter: https://twitter.com/ANBOUND1993
LinkedIn: https://www.linkedin.com/company/anbound
Facebook: https://www.facebook.com/AnboundResearchCentre
Instagram: https://www.instagram.com/anboundthinktank/
Medium: https://anboundkl.medium.com

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ANBOUND is a multinational independent think tank, specializing in public policy research, incl. economy, urban and industry, geopolitical issues. Est. 1993.

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ANBOUND

ANBOUND

ANBOUND is a multinational independent think tank, specializing in public policy research, incl. economy, urban and industry, geopolitical issues. Est. 1993.

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