Postcard From China to Fed: Not Time to Raise Rates

China's move to raise interest rates can serve both as a sneak preview to what might happen when other central banks start down the same road, and as an assurance that the Federal Reserve is nowhere near that point.

The Federal Reserve headquarters in Washington, DC.
The Federal Reserve headquarters in Washington, DC.

The Chinese central bank's move Tuesday to raise key ratesroiled world markets, if only for the day: Currency investors feared the move would slow growth in China, sending forex cash to the US dollar, which in turned helped accelerate a plunge in commodities and the stock market.

While it could be premature to read too much into a quarter-point hike in the global growth engine's rate structure, investors surely took notice—and so must have the Fed.

"There's no way the Fed is going to raise rates in the foreseeable future. The odds of that are nil," said Zach Pandl, economist at Nomura Securities International in New York. "The economy and the markets are much recovered over the last year and a half but still in a very fragile state. It's much more likely that rather than rate hikes there will be further easing in the future."

To be sure, the Chinese move likely had more to do with fighting inflation than as a response to the brewing global currency war. Officials there have been increasingly fearful that runaway inflation may be a negative side-effect of all the growth the nation has been experiencing and derail its standing in the global marketplace.

But markets will pay more attention to what happens when the dollar gains. Investors fled risk assets after the Chinese rate hike and used the US dollar as a safe-haven, boosting the greenback's value. The US government's weak-dollar policy has been at the center of the stock maket's gainsof the past 18 months.

A reaction by the markets similar to the Chinese move is the last thing the Fed wants now.

"The Fed is not unhappy with what the dollar's been doing. They're really focused on internal problems and trying to get the economy going again," said Michael Goldberg, economist at the University of New Hampshire. "Their decision-making is stemming from the belief that the US economy is really struggling, so they've shown no inclination that they're going to start raising rates any time soon."

The relationship the Chinese currencyhas with the rest of the world is unique. Rather than being driven by internal rate policies, the yuan is pegged to be weaker than the US dollar.

Theoretically then, a stronger Chinese currency could be a benefit to the greenbacks as it would make the US more competitive in global exports by making its goods cheaper on a relative basis. But Tuesday's move generated fear that a stronger yuan also might discourage Chinese spending and therefore hamper the global recovery.

So the situation essentially becomes the lesser of two evils for the Fed. Given the choice, the central bank is more likely to take the policy that now is not the time to strengthen the US currency.

"They're finding new ways to increase the balance sheet," said Michael Pento, senior economist at Euro Pacific Capital in New York. "They couldn't be any further away from tightening monetary policy. What happened yesterday can only further their resolve away from strengthening the dollar."

The markets got another clue about the Fed's economic expectations Wednesday when it released the Beige Book report, which analyzes current conditions and sometimes can tip the Fed's hand about future actions. The Fed said economic growth continues in the United States at a modest pace, but did not cite concerns about deceleration, as it did in its last report.

Some economists wondered whether the Fed might try a bit of psychology on the markets as it heads into the November meeting. The central bank could build on the Beige Book sentiment and say the economy is improving at a satisfactory pace and is therefore not in need of more easing help through the Fed's money-printing programs to buy assets—referred to as quantitative easing, or in the coming second major phase as "QE2."

That could be a bad bet, said Lawrence Creatura, portfolio manager at Federated Investors in Rochester, N.Y.

"A significant portion of QE2 has already been priced in by the market," Creatura said. "If it does not happen, the stock market is likely to reverse the direction that we've enjoyed over the past month."

Easing generally depresses the value of the dollar as it increases the amount of money in supply. In QE, the Fed buys securities with money it creates—not physically printing the money but rather crediting its account with funds not previously in circulation.

Treasury Secretary Timothy Geithner on Tuesday pledged, in a Silicon Valley speech, that the US is not engaged in active dollar devaluation. But his statements ring hollow in the marketplace, even though some cited the remarks as another reason why the dollar temporarily rose.

"That is the right thing for our Treasury secretary to say," Creatura said. "However, there's absolutely no evidence that our actions as a nation are consistent with that statement. So there's a credibility issue there."