Bank of the West U.S. Outlook Report for August 13, 2015

Bank of the West US Outlook Report: Dispatches from China

Just when the July employment report and the markets  suggested smooth sailing for the Fed to lift interest rates as soon as September (on Friday the futures market implied probability of a September Fed funds rate hike increased to 54%, the highest it has been ever), China’s economic data and surprise yuan devaluation have muddied the waters.

While advertised by the People’s Bank of China as a logical market liberalization move that keeps the yuan on the path toward reserve currency status, the timing of the currency action doesn’t pass the smell test. The market senses economic policy desperation that has dented investor confidence in the stability of China’s economy and raised fears of a new currency devaluation war in Asia that, if realized, could slow growth and intensify deflationary pressures to the rest of the world.

From the Chinese perspective, the renminbi has been appreciating along with the U.S. dollar over the past year, while other emerging market countries and many of China’s trading partners have seen currency depreciation on looser monetary policy and quantitative easing. This has put additional downward pressure on Chinese exports and manufacturing performance at a time when economic activity in China appears to be continuing to fall short of its annual government growth target of 7.0%.

Despite downbeat indicators of Chinese economic growth, the two-day global market reaction from the yuan devaluation itself does appear to be an overreaction.  In this week’s outlook report we analyze why that is, and even contemplate the economic and inflation implications for the U.S. from a more drastic 10% depreciation in China and many of its largest trading partners currencies.

Our conclusion: the impact from the Chinese yuan policy change should not have earth-shattering consequences for U.S. economic growth or inflation, and should not factor much into the decision on when to raise the Fed funds target rate.  In the end, it shouldn’t necessarily delay an initial Fed interest rate hike in September. However, it does raise the probability that it won’t be followed by others this year, and the path toward interest rate normalization will remain a very shallow one next year.

Check out this week’s US Outlook Report to learn more.