Fed's 'gradual' approach to promoting inflation carries with it its own risks
Global economic engineering is a delicate business
No-one will blink if the Fed raises US interest rates again this week, signalling an end to the cheap-money era. The US central bank raised rates by 0.25 percentage points on Wednesday - its first increase in almost 10 years.
Financial markets across the world initially interpreted the hike as a positive, with benchmark stock indexes surging.
A day later, however, the markets gave back much of the gains. European shares fell in volatile trade on Friday, giving up most of the Fed-inspired gains of the previous session as investors took profits before the holidays.
European stocks had rallied on Thursday as investors took the Fed's decision to raise interest rates as a sign of confidence in the world's biggest economy.
"Yesterday's rally was a bit overdone and investors are taking profit as they prepare for the holidays. Lower oil prices and weaker US markets gave the pretext to sell," said Stephan Rieke, senior economist at BHF-BANK in Frankfurt, speaking on Friday evening.
The Fed will raise interest rates again in the next three months, confident that the US economy - and by extension the global economy - can stand higher borrowing costs after years of stimulus and near-zero rates. However Janet Yellen, who chairs the rate-setting Federal Open Market Committee, made clear future increases would be gradual.
"Defining 'gradual' and divining how the FOMC will implement a gradual rate increase will become the new parlour game for financial markets and monetary policy wonks," William Lee, head of North American Economics at Citi, wrote in a note.
The FTSEurofirst 300 index is up almost 4pc this year but down 14pc from its peak in April. Economic stimulus measures from the ECB have helped underpin European markets this year and are expected to continue in 2016.
A relatively easy decision for the Fed, however, is making life much harder for policymakers on the other side of the world. The People's Bank of China (PBOC) has recently been burning through its $3.4 trillion stash of foreign-exchange reserves, spending nearly $100bn a month to prop up the value of the yuan. Higher US interest rates and a stronger dollar are sure to spur further capital outflows, especially given continued worries about the Chinese economy.
Chinese leaders seem willing to accept some mild depreciation while preparing for full liberalisation of the yuan. In the future, the currency's value may be determined against a basket of 13 currencies including the euro and yen, which would increase downward pressures.
If the PBOC were to pull back now, however, the currency's gentle glide could quickly turn into a nosedive. Given the dollar's strength against emerging market currencies, a true free float could spark a devaluation of more than 30pc.
In that event, China would have few weapons at its disposal. In November, the yuan joined the IMF's elite club of reserve currencies - a victory of great symbolic importance to Chinese leaders. If they imposed capital controls to halt the yuan's downward slide, they'd suffer massive embarrassment, not to mention hard questions about their economic management skills.
China has little option but to continue muddling through, then, allowing the yuan to decline in value while working to moderate its pace. This certainly counts as currency "manipulation" in the eyes of campaigning candidates in a US presidential election year.
In this case, though, China isn't defying the market so much as attempting to cushion market-driven dislocations. The dilemma highlights an uncomfortable truth: Unlike the Fed, whose rate hike is a classic low-risk decision, Chinese leaders today face only high-risk policy choices. And the best they can hope for in return is a degree of stability, not the go-go growth of earlier decades.
Previously, when China's debt levels were low and the government was running large surpluses, investment opportunities were plentiful. Now credit is stretched. Fixed-asset over-investment has left a capacity glut. Migration to cities is slowing.
That said, other countries should recognise the difficulty of transforming the world's second-largest economy. While China must face up to its bad-loan problem, leaders want to avoid issues that might fuel worker protests.
While the country needs to liberalise its currency, it must be granted the leeway to do so in a manner that minimises global ramifications. The world should be rooting for China to succeed. Otherwise the Fed's next decision isn't going to be so easy.