Over the past year, the U.S. dollar has appreciated more than 18%, and in the week of August 10th, China surprised the markets by allowing its currency to depreciate nearly 3% against the dollar, thoroughly roiling the equity markets. The Peoples Bank of China (PBOC) had typically pegged the value of the Chinese currency (RMB) to the dollar. In August, 2014, it took 6.15 RMB to purchase $1; and on Tuesday, August 11, 2015 it took 6.21 RMB. Thus, by pegging to the dollar, China’s currency was appreciating nearly as fast as the dollar. It showed up in their exports. July’s exports were 8.3% lower than those of a year earlier, and they fell a whopping 4.9% between June and July.
One can’t really blame the Chinese for allowing their currency to depreciate against the dollar and put their exports back into price contention. In addition, China has wanted its currency to be accepted internationally. After all, they have the second largest economy in the world and it soon will be the largest. One step in this process was to have the RMB placed into the International Monetary Fund’s (IMF) Special Drawing Rights (SDRs). But, they were recently rebuffed by the IMF which indicated that China was not allowing market forces to set the currency’s value. So, the nearly 3% depreciation in the week ending August 14, 2015 accomplished two things: it made their exports more competitive, and it catered to the desires of the IMF.
The reality here is that the world is still in a deflationary mode, and currency wars have erupted as economies fight for the limited demand for industrial exports. What is really strange, however, is that over the past year the U.S. has refused to defend its export market share, as the U.S. government has taken no official policy position on the value of its currency. In effect, the rapid 18% rise in the dollar’s value has left the U.S. business sector, more specifically, the industrial sector, to bear much of the brunt of the worldwide adjustment to slow worldwide economic growth. Because of the rising value of the dollar, American industrial companies have lost a huge percentage of the export pie.
Under these conditions, the thought of the U.S. Federal Reserve actually raising interest rates appears to be, for lack of a better term, insane. The bank of Canada raised interest rates there three times in the post-recession period, only to unwind two of those this year as their export oriented economy has ground to a near standstill in a stagnant world.
If the Fed’s oncoming rate hike is truly data dependent, as Chair Yellen has insisted, then there should be no rate hike in September, as the labor market seems to be the only area of real strength. Yet, even in today’s apparently strong labor market, wages are not rising.
It could be that the rising value of the dollar has put downward pressure on wages, especially in export oriented industries like manufacturing. All other things equal, the export sales will go to the country with the weaker currency. The only way for the industries in the country with the stronger currency to compete is to lower their prices, which squeezes profit margins. As a result, either the jobs migrate to the countries with the weaker currencies or, if the exporters in the country with the strong currency lower prices to compete, they squeeze their margins and can ill afford to raise wages.
Going back to the Fed’s data dependency, their preferred inflation gauge, the PCE (Personal Consumption Expenditure) Price Index has not been rising and is currently sitting at a year over year growth rate of 1.3%, far below the Fed’s state objective of 2.0%. Furthermore, incoming data still shows at least a 2% gap between potential and real GDP, and U.S. fiscal policy has been tightening dramatically, as the deficit/GDP ratio has fallen from nearly 13% in ’09 and more than 9% as recently as ’12 to about 4.5% in ’15 and projected lower going forward. Finally, the rise in the value of the dollar, itself, according to Wall Street economist David Rosenberg, is equivalent to 200 basis point (2 percentage point) rise in interest rates. So, significant monetary tightening has already occurred.
In conclusion, if the Fed is truly data dependent, it will not raise rates in September. But, they have been talking about this hike since the taper tantrum of ’12, and they have hinted that it would occur in this year’s second half. Unfortunately, an up-move in rates will further strengthen the dollar and place an even greater burden on U.S. industrial exporters. It is a good thing that the industrial economy only represents 12%-13% of GDP. So, while the service economy may continue to expand enough to keep U.S. economic growth between 2% and 3%, the industrial portion of the economy will continue in its current funk, at best, and could possibly fall into recession.
Robert Barone, Ph.D.