The Federal Reserve is Being Held Hostage by China

by John Galt
March 17, 2015 05:15 ET

Please not the following from the Federal Reserve’s FOMC statement:

Information received since the Federal Open Market Committee met in January suggests that economic activity has been expanding at a moderate pace despite the global economic and financial developments of recent months. Household spending has been increasing at a moderate rate, and the housing sector has improved further; however, business fixed investment and net exports have been soft. A range of recent indicators, including strong job gains, points to additional strengthening of the labor market. Inflation picked up in recent months; however, it continued to run below the Committee’s 2 percent longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance, in recent months.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee currently expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market indicators will continue to strengthen. However, global economic and financial developments continue to pose risks. Inflation is expected to remain low in the near term, in part because of earlier declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further. The Committee continues to monitor inflation developments closely.

Against this backdrop, the Committee decided to maintain the target range for the federal funds rate at 1/4 to 1/2 percent. The stance of monetary policy remains accommodative, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.

The portion of the statement that I have highlighted in red is quite disturbing and provokes the following question:

What global economic and financial developments are a potential risk?

The Fed said in December that they were only focused on domestic economic conditions with minor acknowledgements of what is happening overseas. In the mean time a currency war has been raging between the European Central Bank (ECB), Japan, and China. Yet not one word about the monetary conflict nor how the Fed could have helped both Japan and Europe by increasing our Fed Funds rate from the 0.25%-0.50% range up by just one quarter of a point and giving Yellen the now desperately needed credibility which is currently out the window.

Instead of doing what the Fed should have done, they elected to take the easy route, promoting a dovish action and statement by blaming inaction on overseas factors when in fact according to the very inflation and employment data they promote, the Fed should have stayed the course on its original rate schedule as outlined in the December 2015 statement. So what has changed?

China.

The Chinese government is bleeding cash and needs the ability to sell U.S. Treasuries, especially long dated (5 year or longer) issues at the highest price possible. The People’s Bank of China has hinted that they enduring massive capital outflows despite capital controls imposed in 2015. Deutsche Bank has estimated it is far worse with the Chinese foreign exchange war chest losing over $328 billion between August 2015 and January 2016 (information via BusinessInsider).

The chart below from Deutsche Bank highlights the outflow problem in which is now worse than the 2008-2009 financial crisis:

DB_IMPORTS_DISCREP_CHINA

This statement from Deutsche Bank last month explains why the Fed is being held hostage by Beijing:

 This suggests the capital controls in China have not been effective. Many investors are worried that if the current pace of capital outflows continues, China may be forced into a large devaluation of Renminbi, which could trigger turmoil in the global financial market.

The Chinese authorities have likely tried to make capital controls more effective in recent months. The pace of decline in reserves has not slowed, which shows the authorities themselves may not know exactly how the capital has flowed out of the country.

Thus it is only logical to assume to replace the declining amount of dollars being held in China must be replenished and the only method of doing so efficiently and without a rapid depreciation of the Reminbi/Yuan is to sell Treasuries at the highest price possible back to the Fed in addition to quietly liquidating any of the U.S. mega-bubble 10 year Asset Backed Securities from the real estate bubble which are maturing at this time and rolling the proceeds over into short term U.S. Treasuries. The Fed is the only supplier in the world capable of helping the PBOC complete this process without a massive disruption to the Forex and bond markets thus that is why Janet Yellen is cooperating.

As this attempt to prop up the Chinese economy fails also and the bleed of foreign exchange reserves accelerates,  the PBOC may have to finally decide to begin the process of a dollar divorce or double down and impose greater capital controls in coordination with the Federal Reserve. The problem for both central banks is that by engaging in this type of approach instead of letting the Chinese currency float to meet market expectations to a greater degree, they are creating the very situation which will cause the final bubble and greatest market crash in many years:

Markets will give up and lose faith in the current central banking system.

 

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