A Tale Of Two Central Banks, Redux
Are All Monetary Policies Doomed To Fail?
At the last meeting of the Federal Open Market Committee, Jay Powell proved quite frustrating with his word salad answers to questions regarding the future of Fed policy, conveying nothing quite so much as a complete lack of clue about what monetary policy should be.
In other words, the Fed is through raising the federal funds rate and will start cutting that rate. However, it won’t cut until the economy shows that cuts are appropriate, which could mean the Fed will raise rates if the economy goes off on a tangent as it has shown itself able to to do. The economy could shrink, or it could grow, which means inflation could rise or could fall, and so the Fed will raise or lower rates to match whatever the economy does or does not do.
Yet for all his cluelessness, Jay Powell operates with one decided advantage: The Federal Reserve is not the People’s Bank of China. While the Fed dithers about whether to bring the federal funds rate down from historic highs, the PBOC is grappling with how much lower it needs to go with its interest rates to get China’s moribund economy moving again.
China’s lenders cut the country’s benchmark five-year loan prime rate for the first time since June, extending Beijing’s efforts to revive the country’s anemic property market.
The Chinese central bank kept its one-year loan prime rate — the peg for most household and corporate loans in China — unchanged at 3.45%. The benchmark five-year loan rate — the peg for most mortgages — was cut by 25 basis points to 3.95%, according to a statement Tuesday from the People’s Bank of China.
Thus we once again have an opportunity to compare and contrast the Federal Reserve and the People’s Bank of China, and to see how the monetary policies of the two largest central banks overseeing the world’s two largest economies are handling their respective briefs.
Spoiler alert: neither is doing very well.
It has been over a year and a half since the last time I put the Fed and PBOC policies side by side. Perhaps predictably, the conclusion I reached then has not changed: Central banks generally don’t do economic stewardship very well.
What all central bankers fail to apprehend is that, with or without their manipulations, markets happen. This was true when Adam Smith wrote Wealth of Nations and it is true today—in fact, Smith’s key realization was that market dynamics will continue despite any efforts by governments or bureaucrats to steal their thunder.
Adam Smith’s “invisible hand” is, in the end, the only winning hand in any economy.
Ultimately, central banks fail because central bankers fail to understand that not only are they not needed, they are invariably unhelpful. The best thing any central bank—and by extension any government—can do for its economy is to simply step aside and let markets function freely. The moment they intervene in those markets, they diminish the very economy they purport to grow.
Wall Street is certainly having to come to terms with the serial inadequacies of central banking, with the growing realization that the Fed may actually raise the federal funds rate yet again before cutting rates.
It’s taken months to sink in, but traders are finally coming around to the once-unthinkable scenario of possibly no rate cuts in 2024 and now even considering the idea of another hike by the U.S. central bank.
The readjustment in thinking comes after last week’s consumer-price index for January came in hotter than expected and was followed three days later by the producer-price index for the same month, which confirmed that the Federal Reserve’s inflation fight isn’t over.
Why is the Federal Reserve potentially on the cusp of raising and not lowering interest rates? Simply put, the official economic data shows the US economy is just too damn strong for its own good. Time and again, the official metrics appear to show a strong and resilient economy, even though the interest rate rises the Fed has been enacting since the spring of 2022 were intended to weaken the economy. Wall Street is now having to game this latest economic wrinkle, where reality simply refuses to bend to the Fed’s narrative.
Another round of robust U.S. data is set to arrive next week, raising questions in the financial market about whether the economy can continue to avoid buckling under the weight of the highest interest rates in over two decades.
We must keep in mind that a robust economic performance was the one thing Jay Powell has been striving to prevent with his rate hike strategy. Readers will recall that was the core of his 2022 Jackson Hole speech, where he tried to channel Paul Volker and, as per usual, made a complete pig’s breakfast of it.
As has become the norm for Fed remarks of late, Powell wasted no time in jumbling facts and logic in an effort to sound both tough and competent. One suspects he was trying to sound like Paul Volcker circa 1979.
The Federal Open Market Committee's (FOMC) overarching focus right now is to bring inflation back down to our 2 percent goal. Price stability is the responsibility of the Federal Reserve and serves as the bedrock of our economy. Without price stability, the economy does not work for anyone. In particular, without price stability, we will not achieve a sustained period of strong labor market conditions that benefit all. The burdens of high inflation fall heaviest on those who are least able to bear them.
While this was a strong opening, he proceeded to contradict himself almost immediately.
Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance. Reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions. While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.
Inflation means the economy is broken, and so long as there is inflation labor markets will suffer….but to reduce inflation and restore price stability requires breaking the economy and making the labor markets suffer.
However, despite Powell’s insistence on the US economy enduring a forced recession to quash inflation, by the numbers the US economy has thwarted Powell both on inflation and on overall economic performance.
Yields jumped last week after hotter-than-expected consumer and producer price index data. A key subset of CPI services prices advanced by the most in nearly two years. Job gains for January also exceeded forecasts, though a slump in retail sales for the month offered a counterpoint to evidence that the economy continues to expand faster than its longer-term potential.
We should bear in mind that most of the “official” data on the US economy should be taken with a grain of salt, as even the published data is not entirely internally consistent.
Rising inflation and a seemingly “robust” economy (at least, if we look at just the “headline” numbers) are not what the Fed wanted to see not since it began this rate hike cycle.
The PBOC has been grappling with the nearly opposite problem: Despite having cut interest rates and otherwise deployed stimulative monetary policy tools, the PBOC has been unable to achieve a meaningful rebound within Chinese economy, and in the housing markets in particular.
From 2022 to 2023, the central bank cut the loan prime rate and loosened the lower limit on mortgage rates. By December 2023, the average interest rate on new mortgages issued by banks was 3.97%, falling below 4% for the first time.
But home purchases did not increase. The balance of home loans declined for much of 2023 after peaking at the end of March. Downward pressure on prices of existing apartments has increased as sales have slumped.
The PBOC is caught in a monetary policy Catch-22. It needs to lower interest rates to spur homebuying and other economic activity, but pushing rates lower will, at a minimum, weaken the yuan on forex markets—at a time when the yuan is already showing signs of enduring weakness.
Just in 2024 alone, the yuan has dropped 1.5% against the dollar, and that after having dropped 2.8% against the dollar in 2023. At 7.19 yuan to the dollar, China’s currency has sunk to near 10-year lows against the dollar. Further interest rate cuts are not going to help the yuan appreciate against any currency.
Even more stark, however, is the apparent impotence of the rate cuts initiated by China in recent months.
The central bank on Sunday kept the one-year MLF rate unchanged at 2.5 per cent, the lowest level since the rate was introduced in 2014.
In August, the PBoC cut the MLF by 0.15 percentage points and then a week later reduced the one-year LPR by 0.1 percentage point, while keeping the five-year LPR steady. The five-year LPR was last reduced in June.
These incremental rate adjustments have, thus far, not stopped China’s steady slide into deflation.
Yet should the PBOC attempt greater rate cuts, it runs the risk of creating turmoil within China’s already fragile banking sector.
If the property market and the wider economy don't show signs of recovery, the central bank could be pushed to cut rates even further, at the risk of sapping banks' financial strength.
While it cut the five-year loan prime rate on Tuesday, the People's Bank of China left the one-year rate unchanged at 3.45%. Banks' interest margins are already at an all-time low and are below the warning line set by a banking industry self-regulatory mechanism to ensure sound management.
The latest rate cut may have been limited to five-year loans to take into account the profitability of banks as they make provisions for the disposal of non-performing loans.
A weak yuan appears to be another reason Beijing has avoided making deep interest rate cuts. If the yuan continues to weaken, capital outflows could increase. The Chinese currency has been hovering at around 7.2 yuan to the dollar.
With foreign direct investment having collapsed nearly 90% over the past two years, lowering interest rates, and thus incentivizing foreign companies to move their capital elsewhere in search of higher yields, can only make an already catastrophic investment situation even worse.
The PBOC may very well be in a true “damned if they do, damned if they don’t” scenario.
The Fed is similarly caught between a proverbial rock and a hard place. On the one hand, Powell’s rhetoric has committed the Fed to a strategy of rate hikes to bring inflation under 2% year on year, which so far it has not been able to do. Even worse for the Fed has been the reality that consumer price inflation has been trending back up in recent months.
What is arguably worse for both Wall Street and Main Street is that the January inflation report is a confirmation of what I assessed from the December inflation report last month: inflation is “back” in the US economy.
Ultimately, the BLS data shows not only that inflation is “back”, but that in several substantive ways it never really left. The BLS data also shows we’re likely to be stuck with elevated inflation for some time come, as higher inflation rates are becoming embedded in the US economy, even as the economy declines.
That conclusion is reiterated this month as well.
The Federal Reserve is not “winning” its fight with consumer price inflation. “Bidenomics” is not making the US economy stronger. The US economy itself is not doing at all well.
All of which runs counter to the “official” narratives from both Wall Street and Washington—and yet which the sudden realization of which explains the dramatic one day drop in equity indices and the one day surge in Treasury yields.
At the same time, Wall Street has up until recently been convinced that rate cuts were just around the corner, only coming off that stance in January.
Summers’ argument comes just after a big market rethink of where rates are going. At the start of January, the futures market had six quarter-point cuts priced in. These market expectations were always at odds with the Fed’s own forecasts, but traders were betting on a rapid deceleration in inflation this year — like we saw in the back half of 2023. Since January, the macro picture has changed a bit. Inflation is falling slower than expected and the jobs market looks sturdy. That is on top of clear signals from Fed chair Jay Powell that the Fed would take its time before cutting. So rates traders reined in their expectations.
As a consequence of Wall Street’s habits of denial, the Fed is facing more than a few risks should it opt for another rate hike.
One immediate risk of a possible Fed rate hike to financial markets is that such a scenario isn’t currently priced into the 10-year Treasury yield BX:TMUBMUSD10Y against “crowded” equity positions, according to Emons. Rising Treasury yields and higher-for-longer interest rates have a way of unnerving stock investors partly because the future cost of doing business also goes up. As of Tuesday afternoon, the 10-year rate was down by roughly four basis points at around 4.25%.
While the Fed is not quite painted into the same corner as the PBOC, its range of available options is steadily diminishing.
While the Fed has mismanaged monetary policy with respect to this most recent cycle of hyperinflation, we should also note that the Fed has the luxury of a somewhat better basis for making changes to monetary policy.
Despite the Fed’s money printing madness of the past several years, when we look at the World Bank data, we see that broad money growth in China as a percentage of GDP has outpaced the United States by several orders of magnitude.
Given the pace of money creation in China for decades, quite arguably the bulk of their economic “miracle” has been little more than a chimera created by rampant money creation.
Despite China’s far looser monetary policy going back to the 1980s, one structural weakness that has always lurked in the Chinese economy has been its stunted levels of private credit. Since 2011, the United States has had higher levels of private credit as a percentage of GDP than China.
Perversely, the United States has had higher levels of central government debt as a percentage of GDP until very recently.
Far from China’s economy having been a “miracle” over the past several decades, it has in fact been a house of cards, one which may finally be starting to topple. The PBOC’s decades of monetary sins may finally be yielding the inevitable consequence.
The perverse irony of both central banks has been that, while their policies have largely run in opposite directions, both have largely failed.
Despite keeping nominal rates low, the PBOC is failing to spur sufficient credit growth to lift the Chinese economy out of the doldrums.
Despite raising the federal funds rate to its highest level in twenty years, the Fed has not only failed to bring inflation down under 2%, the economy has done the complete opposite of what Jay Powell and the rest of the Fed leadership have stated was their collective goal.
Despite having had decades of lavish money creation, China is experiencing a deflation that is looking ever more like “Japanification”—a decade-long period of stagnation. Rampant money printing is supposed to generate inflation, and China is experiencing the polar opposite.
Despite wanting to see higher unemployment, the Fed has been unable to generate it, even as the number of workers not in the labor force has never recovered from the Pandemic Panic Recession.
Neither the Fed nor the PBOC have been able to implement their respective strategies to any degree of success. The Fed cannot control inflation. The PBOC cannot stimulate the economy. Both tight money (Fed) and loose money (PBOC) policies have failed bigly.
If there is one conclusion to be drawn from both the Federal Reserve and the People’s Bank of China, it is that monetary policy as a tool to micromanage a nation’s economy is a fool’s errand. The best thing any central bank can do for the economy is not a damn thing.
Fascinating topic and, as always, a wonderful and enthralling analysis, Peter!
‘Monetary policy Catch-22’ says it in a nutshell for China. I would expect that now the only course of action open to the CCP is to somehow ‘force’ Chinese citizens to buy real estate. Something along the lines of ‘If you want to keep your job, you must show proof of having bought a home’, or ‘if you want a place to live, you must purchase it (even if that destroys your financial future)’. Such draconian measures will only increase the desire of citizens to get themselves and their funds out of the country, but maybe it will also be the last straw on the camel’s back of their frustration. What do you think, Peter - is there some less authoritarian financial pathway that the CCP would attempt first?
As for the US, I’ll bet the Fed will just muddle through, trying to minimize their damage, until the Election is over. After that, the consequences will catch up with us, but will be blamed on the new administration. If the current Democratic administration thinks Trump really is going to win, they have incentive to make the economy look good until November, then thoroughly let it tank after that, so that the Democrats can get back into power four years later. (And this is the political game played decade after decade, to our detriment.)
What I’m wondering, is if China very rapidly declines between now and November, with its foreign investment and citizens’ capital continuing to leave and much of it being reinvested in the U.S., how much of that reallocation will help us? Would it be substantial enough to offset the damage caused to global economies from China’s meltdown? (Probably nowhere near enough.) Any thoughts on the near-term chain of economic events, and it’s effect on our Election?