Why the Fed’s hawkish inflation turn isn’t necessarily bad news for China’s economy

The fiscal and monetary policy options at Beijing’s disposal should insulate it if tighter Fed policy tips the US economy into recession
The combination of broad pledges of government support and a shift towards an economy more driven by domestic demand will ease China’s exposure

Neal Kimberley

Published: 3:30am, 23 Mar, 2022

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The US Federal Reserve has finally rediscovered its inner hawk and kicked off what will be a succession of interest rate increases. Quantitative tightening will surely join the policy mix. There could be spillover effects that affect the Chinese economy, but Beijing has mitigating fiscal and monetary policy options at its disposal.

China is at a completely different stage in the economic cycle to the United States. The Fed is focused on inflation while Beijing’s priority is supporting the pace of economic growth, but the steps Beijing is adopting are also the policies that should stand China in good stead if Fed tightening ultimately tips the US economy into recession.

Fed chair Jerome Powell says that “the probability of a [US] recession within the next year is not particularly elevated”. Either way, having until recently categorised rising US prices as “ transitory”, the central bank is now determined to drive down US consumer price inflation. That figure was 7.9 per cent year on year in February, which stands in stark contrast to China’s annualised 0.9 per cent reading last month.

Last week, the Fed increased its benchmark interest rate by 25 basis points to a target range of 0.25 to 0.5 per cent. It now appears set on further rate rises over the course of 2022 that should lift the key Fed funds rate to 1.9 per cent by the end of the year, with more increases next year taking it to 2.8 per cent by the end of 2023.

No one can know whether the Fed tightening cycle will play out like this. Some would argue that if US financial markets take fright as these rate increases are announced, the Fed will pull back.

But no one should underestimate the significance of the Fed rediscovering its fervour for tackling inflationary pressures. If US inflation proves stubbornly resistant to initial policy tightening, the Fed might feel compelled to keep going, even at the risk of starting an economic recession.

Crimped US growth or a recession would weigh on consumer demand and the ability of American consumers to buy Chinese-manufactured goods. As it is, Chinese policy settings suggest that the country would be reasonably well placed to cope with such an outcome.

In any case, China is seeking to move to a “ dual circulation” economic model that is less export-centric and more driven by domestic demand. While that will take time, any progress leaves China’s economy less exposed to a US economic slowdown.

But there are other issues that also need to be considered. No one in mainland China or Hong Kong needs reminding that, despite containment efforts and vaccinations, Covid-19 still constitutes a health emergency. Containment-related lockdowns, while deemed necessary, also have adverse local economic consequences that require mitigating fiscal and monetary policy support.

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That support has been forthcoming. Vice-Premier Liu He stressed last week that Beijing would roll out a variety of broader fiscal measures to shore up first-quarter growth and bolster capital markets.

China continues to aim for GDP growth of “around 5.5 per cent” for 2022. In the monetary policy space, the People’s Bank of China (PBOC) remains supportive. China’s central bank might cut interest rates further, even as Fed increases erode the nominal China-US yield spread that currently favours yuan-denominated interest-bearing instruments.

In reality, investors might focus more on the real, rather than the nominal, China-US yield spread. As Yu Yongding, a former member of the PBOC’s monetary policy committee, told the China Securities Journal on March 14, real US interest rates are negative when adjusted to take into account inflation while real Chinese rates are positive.

Positive real Chinese interest rates arguably underpin yuan strength. That matters, given that China is such a huge importer of raw materials to support its economy, and pandemic-related supply chain shocks – compounded by the economic side effects of Russia’s invasion of Ukraine – have sent commodity prices soaring.

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Some degree of yuan strength is a partial buffer against imported inflation via elevated US dollar-denominated commodity prices.

Possible spillover effects from the Fed tightening cycle only add to the issues confronting the Chinese economy in 2022. However, the good news is that Beijing still has a variety of fiscal and monetary policy levers to pull, to help overcome the challenges.

Neal Kimberley is a commentator on macroeconomics and financial markets