US-China Trade Talks and American Strategy

The United States is shifting from military to economic warfare.

By George Friedman


As the U.S. continues to negotiate a trade deal with China, a shift in American global strategy has emerged. The United States is reducing its use of direct military action and instead using economic pressure to drive countries like China, Russia, North Korea and Iran into conceding to U.S. demands. Even in places where the U.S. is still engaged militarily, such as Afghanistan, serious talks are underway for a withdrawal. It’s a shift that has been long in the making. In my book “The Next Decade,” published in 2011, six years before Donald Trump took office, I argued that the United States would reduce its military activity dramatically because it couldn’t maintain the tempo of engagement it had established over the years. I also discussed the topic in a 2018 article titled “The Trump Doctrine,” which argued that the United States would eventually be forced to scale back its foreign engagements. The use of economic power to shape behavior isn’t new; what is new is the focus on economic rather than military warfare.
An Inexperienced Power
The U.S. is a global power, engaged and exposed in many theaters. Having used its military presence in far-flung corners of the world as a symbol of its global reach and superiority, the U.S. spread itself thin and became unable to defeat even enemies whose forces and capabilities were far inferior. The classic example is Korea in 1950, where the United States had deployed an insufficient force, a result of the military drawdown. The North Koreans chose to strike, compelling the U.S. to fight for three years to a truce that left the North Korean regime intact and the boundaries roughly the same as before the war. The U.S. could not initiate war with the force it had. The North Koreans could and did.

Since World War II, the United States has been victorious in only one major conflict: Desert Storm. For 28 of the past 74 years, the U.S. has been at war in places like Korea, Vietnam, Afghanistan and Iraq but has failed to achieve victory in most cases. Neither Rome nor Britain used main force to wage wars. They relied instead on capable local powers with an interest in defeating the same enemy to do most of the fighting. They underwrote the conflicts and supplied some minimal force and material aid, but they tried always to limit their own exposure. The United States, a much younger and more inexperienced power, has consistently used its own force as the main combatant, and failed.


There is a core geopolitical reason behind the U.S. failure in these wars. The United States has fought most of its conflicts in Europe and Asia, where force deployment is a substantial logistical effort. The challenges of intercontinental logistics limit the number of troops that can be sent. More important, the moment the United States sets foot in Eurasia, it is vastly outnumbered. The U.S. has tried to overcome this challenge through technology, but as we saw in Korea, technological superiority is enough to contain the enemy but not enough to defeat it. In Vietnam and the Middle East, the United States fought dispersed forces, native to the area and therefore with better intelligence on American forces than the Americans had on them.

The U.S. failures were also due in part to the fact that no one could define what a sufficient force was, and even if they could, it would likely be much larger than what the U.S. was willing to commit to the effort. The U.S., therefore, fought long wars based on the mistaken belief that the force it was willing to supply was enough to defeat the enemy. And while the United States is outstanding in conventional war, it’s not good at occupying a country that is unwilling to be occupied.
Charting a New Path
Inevitably, the time came when the United States recognized that continuing to do what it had been doing for years and expecting a different result was insane. And so, it has developed a new path, one which Trump has followed in his dealings with several countries thus far. The first step in this new strategy is to intimidate the adversary. When that doesn’t work, threaten to carry out military action without actually doing so. The final step is to resort to economic warfare by initiating or extending sanctions or a blockade. (In some cases, Trump has used some military force to enforce sanctions but, rather than going ashore, has used the Navy as the primary vehicle of military operations.)

It’s within this context that we should view the U.S.-China trade talks. Chinese trade practices seen by Washington as establishing an unfair advantage for Chinese producers is a reasonable topic for discussion and negotiation. But such negotiations are also a powerful alternative strategy for dealing with China’s potential emergence as a global power. For Beijing, the buildup in the South China Sea is an attempt to break out of the ring of islands surrounding the sea and, therefore, undermine a geographic advantage the U.S. would have if it chose to blockade China. The U.S. wants to retain this advantage. But even more important, it also wants to retain the Western Pacific – a region from which it fought to expel Japan during World War II – as a buffer against Asia. If China broke out of the South China Sea, it could become a Pacific threat. The U.S. could prevent this from happening by committing a major military force to the region. It could also initiate an attack on the Chinese navy. But it also has a third option that requires no military commitment at all: impede the reason for China’s policy in the South China Sea in the first place – securing safe passage for Chinese exports.



China is heavily dependent on exports, which account for roughly one-fifth of its gross domestic product – possibly more given doubts over the accuracy of Chinese GDP figures. About 18 percent of Chinese exports are destined for the United States. In contrast, U.S. exports to China account for only about 0.5 percent of U.S. GDP. This is classic asymmetric warfare. China is far more dependent on its exports to the United States than the United States is on exports to China. Certainly, some Americans will be hurt by a trade war, but the U.S. as a whole is much less vulnerable than China is. The U.S. has therefore found a way to threaten vital Chinese interests without threatening war (though it also has some forces located near the South China Sea).

The U.S. has applied a similar approach to Iran, whose expansion throughout the Middle East is a concern for the U.S. and its allies. It’s questionable whether military action against Iran would succeed, so the U.S. has resorted to economic warfare here, too. It pulled out of the nuclear deal and imposed sanctions on Iranian energy exports that have hurt the Iranian economy. As for North Korea, the United States, in concert with the United Nations, introduced strict sanctions to try to limit Pyongyang’s nuclear program. It even seized a North Korean cargo ship last week that allegedly was used to violate sanctions. Similarly, the U.S. has accepted that it can do little militarily in eastern Ukraine or Crimea, but it has organized painful sanctions against Russia and made clear that additional sanctions are possible.

The U.S. is the world’s largest military power, but it is also the world’s largest economy and importer. For the most part, U.S. military engagements over the past 74 years have not ended well, but the use of economic warfare, which takes advantage of the fact that China and other countries are heavily dependent on the U.S. market, gives Washington an alternative to the military option.

It is not clear whether Trump will continue to use this approach, but thus far he has done so. As I have argued elsewhere, political leaders’ actions are shaped by geopolitical reality. The geopolitical reality of our time is that economic action has emerged as a major foreign policy tool of the United States.

Succession questions

Mario Draghi’s successor at the ECB has plenty to do

The ECB has come into its own, but 2019 will still be a momentous year

THE HEADQUARTERS of the European Central Bank (ECB) tower over the river Main. The institution has been equally imposing in the life of Europe’s monetary union. As its only policymaker, it rescued the euro from financial and sovereign-debt crises, and powered a recovery in 2015-17.

But it cannot rest on its laurels. This year promises to be one of high drama. Three of its six-strong executive board will depart, notably its president, Mario Draghi, and its chief economist, Peter Praet (see graphic). By the end of the year eight of the 19 national central-bank governors on its rate-setting body will have stepped down. The end of Mr Draghi’s eight-year tenure coincides with European elections and the top jobs in Brussels coming up for grabs. That makes the choice to replace him unusually political. Should their quest for the commission or council presidencies fail, the French or Germans could seek to put a compatriot—or in the Germans’ case another hawkish northerner—into the ECB job as a consolation prize.

All this could alter the course of monetary policy. Poor choices could mean blunders in dealing with a slowing economy or too-low inflation. The bank’s hard-won credibility as the guardian of the euro could come under threat.

The ECB was set up in 1998, a central bank without a fiscal counterpart. To soothe German fears that it would go too easy on inflation, it was based in Frankfurt and modelled on the Bundesbank. Its intellectual direction came from its chief economist, Otmar Issing, a former Bundesbank rate-setter. Like other central banks, it targeted inflation. But to appease the Germans, it also concerned itself with the rate of money-supply growth.

Two decades on, the Bundesbank’s influence has waned. The ECB focuses less on the money supply, after its link with inflation proved wildly unstable. Philip Lane, a doveish Irishman, takes over as chief economist in June. Neither the economic nor monetary-policy areas is overseen by a German staff member.

To see why the choice of successor for Mr Draghi is so important, consider what he has done—and left undone. Observers are gushing: one compares him to Cincinnatus, a loyal citizen who saved the Roman republic from invasion. His open-minded pursuit of price stability led to the use of unconventional tools such as quantitative easing (QE) to stave off deflation, despite northern members’ horror of monetising government debt. Like other central banks, the ECB has gained bank-supervision and macroprudential powers since the crisis.

Fittingly for a governor who sees communication as central to his role, his biggest policy intervention was uttered but not implemented. In 2012 he said he would do “whatever it takes” to save the euro, promising to buy unlimited amounts of government bonds if sovereigns hit trouble. The ECB’s communications compare well with those of other big central banks, says Marcel Fratzscher, a former staffer now at DIW, a think-tank. Recent policy shifts have caused remarkably little market volatility, unlike some by the Federal Reserve.

The next boss, though, will need to overhaul the bank’s monetary-policy strategy. Mr Draghi seems almost certain to depart having never raised interest rates; price pressures and inflation expectations, currently subdued, are likely still to be well below target. An economic slowdown kiboshed rate rises this year: on April 10th the bank promised to keep them on hold in 2019. They are already at rock-bottom levels, and the bank has bought €2.6trn ($3trn) of government bonds. Should the slowdown worsen, the new boss will have to find the firepower to reassure markets.

The ECB’s independence is a matter of international law. EU members must all agree to any changes to its mandate. But another risk defies any attempt to legislate: that of politicised appointments to its governing council. National central-bank governors are often picked for reasons of domestic politics. The march of populism across the continent complicates matters. Austria’s incoming central-bank boss has no monetary-policy experience and is reportedly linked to the FPö, a hard-right party. Italy’s populists want to “reboot” their central bank’s management.

Such appointments could exacerbate divisions among the governing council, which tend to be along national lines. It must set policy for the euro zone as a whole. But some members still play to domestic audiences. Take the decisions to announce outright monetary transactions (OMTs) that backed up Mr Draghi’s “whatever it takes” commitment, and to begin QE. Both were attacked by some northern central-bank governors and faced legal challenge in Germany. Jens Weidmann, the head of the Bundesbank and a possible successor to Mr Draghi, testified against OMTs.

One interpretation of a ruling on QE by the European Court of Justice in 2018 is that the ECB has room to raise self-imposed limits on the share of government bonds it can buy in each member country. But heightened national divisions would make it harder to build support in the governing council. It might not help that, according to the Eurobarometer poll, public trust in the bank is far below pre-crisis levels both in countries like Spain and Greece, where the ECB is regarded by some as partly to blame for austerity, and in Germany, no fan of low interest rates and bond-buying.

As the ECB gains powers, clashes with politicians become more likely. It now oversees large lenders, in which governments also take a keen interest. Last year, under pressure from the European Parliament, its supervisory arm toned down a plan to ask banks to make more provisions for non-performing loans. It also withdrew a request for new powers to centralise the regulation of clearing houses. Governments had sought to narrow their scope; the bank says that threatened its ability to conduct independent monetary policy.

The ECB keeps banking supervision and monetary policy quite separate. But the president will set the tone of its response to political pressure, argues Sir Paul Tucker, a former deputy governor of the Bank of England who has written a book on the power of central banks in democracies. And Mr Draghi’s successor will need great skill to nudge governments to speed up fiscal and banking reforms, he says, to avoid monetary policy being the only game in town.

That person will have to direct the bank’s efforts to return inflation to target, and perhaps deal with a recession, while balancing competing political interests. If its only functioning economic institution stumbles, so too will the euro zone.

Bruised Retailers Face More Pain

Retail stocks, already down on tariff worries, could be hit further this week as retailers begin reporting earnings

By Michael Wursthorn

Macy’s reports quarterly earnings this week. Like other retailers, it must decide how to respond to increased tariffs on goods from China. Photo: paul j. richards/Agence France-Presse/Getty Images

Shares of retailers, buffeted by rising trade tensions in recent sessions, face a key test this week when Macy’s Inc., M -0.87%▲ Walmart Inc. WMT +0.00%▲ and others begin reporting quarterly earnings.

The S&P 500 Retailing index fell another 3.2% Monday, extending last week’s 3% slide after President Trump pushed ahead with tariff increases on billions of dollars of Chinese imports. That outpaced the broader S&P 500’s 2.4% decline Monday, as shares of Macy’s, J.C. Penney Co. JCP -2.38%▲ , Best Buy Co. BBY +0.21%▲ and Ralph Lauren Corp. all fell more than 3%.

The slides could worsen later this week once retailers begin reporting earnings, analysts said.

Investors will want details on how merchants plan to absorb 25% tariffs on more than $40 billion of goods that are imported from China and directly purchased by U.S. consumers. Macy’s and Walmart are among the first to release results, with reports due Wednesday and Thursday, respectively.

The tariffs, which took effect Friday, hit clothing, luggage, handbags and furniture, among other consumer products. And retailers have few options: They can absorb the added costs themselves, spread them across their vendors or pass them on to customers.

None of those options is particularly attractive, analysts said, and retailers’ pain could signal broader implications for the U.S. economy. Initial estimates project the additional tariffs will shave 0.3% from U.S. growth this year.

“When this tariff conversation started last year, retailers were in a stronger position,” said Simeon Siegel, a senior retail analyst at Instinet. At the time, economic conditions were better and retailers were cutting back on inventories. “But now, things have normalized, inventories are up again and retailers can’t really raise prices,” Mr. Siegel said.

Profit margins are already under pressure, as companies such as Walmart and Target Corp. TGT -0.39%▲ have been spending heavily on upgrading their digital capabilities and remodeling their stores. Absorbing higher tariff-related costs would further stifle margin expansion, analysts said.

In the previous earnings-reporting season, both companies reported slimmer profit margins, but results were upbeat overall, helping to send their shares higher. Walmart’s stock remains up 7.2% this year, while shares of Target have added 8.5%.

Consumer-discretionary stocks, excluding internet retailers, are expected to log a 5.2% contraction in first-quarter profit margins from a year earlier, according to data compiled by Credit Suisse. Margins among consumer-staples companies, which include Walmart, are expected to shrink 5.8%.

That could lead retailers to raise prices in an effort to protect their margins, analysts said, but companies run the risk of stifling revenue if customers pull back on spending. Consumers’ pockets appear relatively healthy thanks to a tight labor market and rising wages. But retail spending has been mixed in recent months following a weak holiday sales season, a sluggish February and a rebound in March, according to Commerce Department data.

With a 25% tariff on apparel items, retailers would have to raise prices by 2.3% to maintain their gross margins, according to analysts at Bank of America. If they can’t raise prices, analysts say the tariffs could compress retail earnings by 39% this year.

Some companies have been trying to insulate themselves from the U.S. and China trade spat, which could soften the blow of tariffs, analysts said. Several companies have been shifting production from China to other Southeast Asian countries in recent years. Others had been rushing goods over from China, ahead of the tariffs, Credit Suisse’s retail analysts wrote in a note recently.

Even if the fallout isn’t as bad as expected, the market has reacted harshly to the idea of tariffs. Last year’s volatility was spurred, in part, by President Trump’s protectionist policies. And the S&P 500’s 2.2% slide last week—its biggest weekly loss of the year—came after President Trump’s initial threat to raise the levies on Chinese imports.

The S&P 500 took another leg down Monday after China retaliated Monday by raising tariffs on about $60 billion of U.S. goods, falling 2.4% for its biggest daily decline since Jan. 3. As long as tariffs remain in place, investors’ doubts alone could be enough to drag retail-stock prices even lower.

“The fear of global trade…deteriorating amid macro fears during previous U.S./China escalations” had the biggest impact on stocks over the past six months, Credit Suisse analysts said, even though costs didn’t drastically increase.

Investors wrongfooted by downturn at emerging Asian economies

Some analysts expect the headwinds facing the region to last for some time

Jonathan Wheatley in London

Analysts expect the Indonesian central bank to join the rate-cutting club by the end of the year © Bloomberg

The engines of the world economy are sputtering. Last week the central banks of Malaysia and the Philippines cut their interest rates, to the surprise of many observers. Indonesia, which begins a two-day policy meeting on Wednesday, is expected to stay on hold. But, increasingly, analysts expect the central bank to join the rate-cutting club by the end of this year.

This is not what many investors expected from emerging Asia, often seen as one of the few parts of the world able to deliver solid and sustainable economic growth.

Capital Economics, a consultancy, blamed a “sharp slowdown” in Malaysian growth and “underwhelming” growth in the Philippines, along with benign inflation, for last week’s rate cuts. It said its proprietary growth tracker also pointed to a sharp slowdown in Indonesian output in the last quarter of 2018, and saw gross domestic product growth slowing further this year.

Adam Wolfe at Absolute Strategy Research, a consultancy, expects the headwinds facing the region’s economies to last for some time. “You still have significant drag from [negative] global export growth and we haven’t seen the bottom yet,” he said.

Widely followed data on world trade volumes from CPB of the Netherlands show that global exports, on a rolling three-month basis, began contracting in December and were down more than 2 per cent in February, the most recent month of data.

ASR’s proprietary leading indicator for Asia ex-Japan, meanwhile, has just turned negative for the first time in more than three years. Industrial production in the region, too, has taken a downward turn in recent months, to its lowest level in more than a decade.

Mr Wolfe says the semiconductor cycle is especially problematic, as the industry awaits the roll-out of 5G mobile internet technology. “Until semiconductor prices firm up and feed into the electronics supply chain, it is hard to see a pick-up in regional growth,” he said.

China’s economy has a dominant influence. Steel production there, Mr Wolfe notes, has been propping up economies in the rest of emerging Asia but has slowed significantly this year.

“If that were to turn over, it would point to further downside risk,” he said. Such concerns are fed by weak housing demand in China, and limits on the ability of Chinese local governments to raise finance for infrastructure investment, he added.

Others say fears of a regional downturn have been exaggerated. Sergi Lanau of the Institute of International Finance expects Chinese growth to stabilise around its current level and for other countries to keep up a healthy clip.

“Unless you think the world is really going to deglobalise and Asia won’t be central to the supply chain any more, I don’t see why that picture would change in the next four or five years,” he said.

Tales From The Casino, Part 1: Funds That Bet On Volatility Might SPIKE Volatility, Crashing The Markets

by John Rubino

It’s a measure of modern financial markets’ absurdity that bets on bets on bets have come to seem normal. Maybe acronyms like CLO and CDO make them sound scientific. Or maybe it’s the sense that if Wall Street’s “rocket scientists” create something it must be highly advanced and therefore beneficial for society.

But in reality, the casino is just adding new kinds of roulette wheels and slot machines, from which society derives exactly zero net benefit.

So it should come as no surprise that the multi-billion-dollar funds that bet on volatility (that’s right, betting on market volatility is now a career) have grown to the point that they can actually cause the volatility they “invest” in – with systemically dangerous results. From Saturday’s Wall Street Journal:

Volatility Could Cause More Pain as Funds Betting on Quiet Sell Down Stocks 
Recent swings in the stock market are threatening to unravel multibillion-dollar bets that rely on calm markets, potentially adding to investors’ jitters over the past week. 
Computer-driven volatility-target funds generally scoop up riskier assets like stocks during calmer periods, hoping to gain as markets grind higher. When volatility hits, it sends them scrambling to sell their stocks and move into safer assets like Treasurys.  
Asset managers like Vanguard Group and insurance companies run some of the bigger strategies of this type. 
Because markets have been so quiet this year, with the exception of episodes like Tuesday’s trade-driven pullback, the funds are especially loaded up on stocks. That has left volatility-target funds carrying the highest level of exposure to U.S. stocks since the fall, a troubling sign for those who believe the funds exacerbated some of the market’s worst selloffs in 2018. 
Volatility-targeting funds had an estimated 44% equity exposure Tuesday. That marked their highest level of equity exposure since early October, when they had a more-than 60% exposure to stocks, according to Pravit Chintawongvanich, an equity derivatives strategist at Wells Fargo Securities. 
After stocks tumbled Tuesday, Mr. Chintawongvanich estimates those funds sold about $10 billion in stocks a day later, knocking their allocations down to 41%—still around their highs for the year. 
“If the next spike [in volatility] is higher, then you’ll see a more extended downmarket and we’d remove equities. You can get easily whipsawed,” said Duy Nguyen, a portfolio manager and chief investment officer of Invesco Solutions, who helps manage these strategies. 
That’s especially true because analysts estimate volatility-target funds manage as much as $400 billion in assets—giving them considerable heft in the stock market. 

Critics argue that such funds, along with the growing prevalence of automated trading, have altered the market’s natural tendencies, from sharpening moves in the S&P 500 to fueling historic stretches of tranquility, like in 2017. 
With dozens of volatility-targeting funds employing similar, but nuanced, automated approaches around insulating investors from the stock market’s shocks, they typically sell stocks simultaneously during the worst downdrafts, analysts said. The group’s equity allocations swung from 83% in late December 2017 to 21% in February following 2018’s initial selloff, according to Wells Fargo. Allocations rose again in subsequent months, hitting 67% in early October, prior to the market’s decline, and bottomed out at 16% in late December. 

Those moves weren’t spread over a long period. Instead, funds sold most of those assets over a few trading sessions, making their impact on the market that much more apparent, analysts said. If Tuesday’s decline had been more severe, on the scale of a 3% pullback in the market, Wells Fargo estimates that volatility-targeting funds would’ve sold roughly $36 billion worth of stocks. 
“You can see these funds moving together,” said Damian McIntyre, a portfolio manager at Federated Investors, who manages a volatility-targeting fund that is near the top of its equity-allocation range. “That can exacerbate any selloff.”

Why is the propensity of volatility funds to intensify crashes systemically dangerous? Because there’s now so much bad debt in the world that a garden variety equities bear market can spread to previously more-or-less unrelated sectors like emerging market debt, energy sector junk bonds and Italian government paper. Let several such dominoes fall together and a localized crisis becomes global.

Meanwhile, volatility funds are just one part of a growing constellation of strategies that rely on algorithms to move money in response to changing market dynamics. The interesting part of their story will be when they (as they eventually must) all move the same way at the same time.

This multi-market interconnectedness is one of the reasons the world’s central banks abandoned their tightening plans so quickly when US stocks fell late in 2018. They know what happens if such a decline accelerates. And the wiser among them know that contagion is coming no matter what they do to stop it.

viernes, mayo 17, 2019



How to Fix the Federal Reserve

By Matthew C. Klein 

The U.S. Federal Reserve building in Washington. Photograph by Win McNamee/Getty Images

The U.S. is now experiencing one of the most benign economic environments in decades. That better last, since it is unclear how effectively the Federal Reserve can respond to a future downturn.

Historically, the Fed has fought recessions by lowering real short-term interest rates at least five percentage points. It will probably not have that option next time. Today, the policy rate is just under 2.5% and unlikely to rise much further. A study published by Fed economists in January warned there is at least a 40% chance the central bank won’t be able to cut interest sufficiently in response to a downturn before the end of 2027.  
This explains why America’s central bank is spending this year reviewing “the strategies, tools, and communication practices it uses to pursue its congressionally assigned mandate of maximum employment and price stability.” It is never too soon to prepare for future trouble.

As Fed Vice Chairman Richard Clarida explained in a speech on Tuesday, policy makers will try to answer three basic questions. First, should the Fed aim for 2% inflation each year, or should it “aim to reverse past misses of the inflation objective” so that prices rise by 2% a year on average? Second, does the Fed need to expand its “toolkit” to boost the economy? Finally, how should the Fed communicate to traders and the general public?
Clarida’s first question is motivated by the concern that persistent shortfalls have permanently altered people’s confidence in the Fed’s existing 2% inflation target. That sounds worrying, but in practice, the price index tracked by the Fed is so divorced from most Americans’ lived experience that small differences in measured inflation probably don’t matter much. Income growth matters far more, and incomes are only loosely related to consumer prices.

According to the Fed’s preferred measure of inflation, health-care costs are based on what doctors, hospitals, and pharmaceutical companies receive, not what consumers pay in premiums and deductibles. Most Americans own their own homes, but their housing costs are based on estimates of how much they would pay to rent their residences rather than their actual mortgage payments. The cost of bank accounts is imputed from the spread between what banks pay savers and what they earn at the Fed. These three categories account for nearly half of the Fed’s index. At the same time, the government’s estimates of the costs of manufactured goods, computer software, and internet services are all sensitive to judgments about quality improvements over time.
The answer to Clarida’s second question is clearly “yes.” The same Fed study warning about the risk of hitting the lower bound on interest rates also warns that none of the “unconventional policies” deployed since the crisis “meaningfully contains the sharp rise in the unemployment rate” in their recession simulations.

Before joining the Fed, Clarida had suggested capping long-term interest rates, which the Bank of Japan has been doing since 2016. Mike Konczal and J.W. Mason of the Roosevelt Institute argue the Fed should lend to state and local governments and give banks cheap funding in exchange for boosting credit supply. In addition to these options, the Fed could also lend directly to households and small businesses, depreciate the value of the U.S. dollar by buying foreign currency, and potentially purchase hard assets such as real estate and precious metals. (Many of these ideas would require tweaks to the Federal Reserve Act.)
As to Clarida’s last question, the Fed’s recent embrace of “transparency” has likely created at least as many problems as it has solved. Despite claiming that monetary policy works by setting expectations of future interest rates, Fed officials frequently complain that traders overreact to their projections. Stephen Morris of Princeton University and Hyun Song Shin, now the head of research at the Bank for International Settlements, warned about this problem shortly before the financial crisis and compared modern central bankers to Soviet planners whose interventions corrupted market signals.

Those are our thoughts. The Fed will publish its conclusions sometime in the first half of 2020. •

Rip-Roaring Chinese Exports Less Than They Appear

Investors shouldn’t read too much into stronger March data from China

By Nathaniel Taplin

The bounce back in Chinese exports in March may be due in part to the timing of the Lunar New Year holiday. Photo: Chinatopix /Associated Press 

To everything there is a season – especially in China.

Friday’s very strong March export figure, up 14% on the year after falling 20% in February, wasn’t exactly a surprise. Much ink was spilled on very weak Chinese exports and industrial profits in February, so expect more on this big export rebound.  
Yet all the figures were heavily distorted by last year’s Lunar New Year holiday, which came on Feb. 16, the second latest in a decade. The timing of the weeklong holiday in 2018 meant a strong February and a weak March for China last year. In 2019, the Year of the Pig, investors should be expecting the opposite, and not read too much into it.

Luckily there are some hints of where things really stand. What those show is evidence of an incipient rebound, but a weak and poorly-established one.

Export growth probably did improve a bit early in 2019: exports for the first quarter as a whole were up 1.4% on the year, compared with a drop of 7.6% in December. The import data is more concerning, though. Despite sharply higher oil and iron ore prices since December, first quarter imports were down nearly 5%. Domestic demand remains shaky.

The more important data for March was lending data, also released Friday – and it sent a similar signal. After a brutal 2018, credit conditions finally are loosening for privately-owned and smaller companies. Yields on low-rated bonds have fallen about half a percentage point since late 2018.

And, continued rhetoric on “deleveraging” aside, Beijing’s crackdown on shadow banking has begun to ease too – a concession to the reality of the private sector’s financing needs. Official data showed shadow credit outstanding still down on the year in March, but the pace of contraction leveling off and up from the previous month.

All this loosening remains quite mild by past standards, however. Private sector borrowing costs have eased, but they remain far higher than the last easing cycle and the overall credit rebound is weak. The central bank’s preferred measure of outstanding real-economy finance rose 10.6% on the year in March, up from a low of 9.8% in December. During the last credit cycle, however, that same measure accelerated about five full percentage points.

China’s economy is out of the deep freeze. With world trade shaky and credit growth still modest, though, a piping hot late 2019 looks unlikely. A lukewarm meal is still the most probable outcome.

Public Policy

Is the Fed’s Independence on the Line?

Wharton and other experts discuss the risks posed by the most recent nominees to the Federal Reserve Board.

What You Don’t Know about the Federal Reserve

President Trump’s choice of Herman Cain, a businessman, and economist Stephen Moore as his nominees for the Federal Reserve Board is raising questions about White House’s attempts to influence central bank policy.

Cain is a business executive who is best known for his aborted bid for the Republican presidential nomination in the 2012 election and as the former CEO of Italian fast-casual restaurant chain Godfather’s Pizza. He also served on the Federal Reserve Bank of Kansas City in alternating roles as chairman and deputy chairman between 1995 and 1996. Moore is an economic commentator who was an adviser to the 2016 Trump campaign and the 2012 Herman Cain campaign. He has also worked as chief economist at The Heritage Foundation, a conservative think tank, and on the editorial board of The Wall Street Journal.

“There is a constitutional duty the president has that should be respected, and that is … a very important role in shaping policy, including that at the central bank,” said Peter Conti-Brown, Wharton professor of legal studies and business ethics. The president can nominate candidates to the Board of Governors, which are confirmed by the Senate. Thus far, Trump has made “stellar appointments” to the Federal Reserve, he said, noting that four of his six nominations have been approved.

However, the Cain and Moore nominations are “very different,” Conti-Brown continued. “President Trump is now abandoning what has been a bipartisan consensus stretching back at least 40 years that says although Democrats and Republicans will appoint different kinds of central bankers, they come with a baseline of competence and experience where they’re not going to prize partisan loyalty over the work of central banking. Stephen Moore and Herman Cain do not fit that historical consensus.” The two nominations represent “a big departure even for President Trump,” he added. “The Senate Republicans and the Senate Democrats need to rally together and vet these candidates and reject them.”

If Cain and Moore were to become Fed governors, “they could poison the conversation,” said Lisa D. Cook, associate professor of economics and international relations at Michigan State University. She noted that Moore has called for the elimination of the Commerce Department as well as the Bureau of Labor Statistics, which is problematic because “for a sophisticated, multitrillion-dollar and very advanced economy like ours, we need all the information we can get.”

Dire Scenarios

“I’m pretty sure these nominees, if they get officially nominated, would do what [Trump] wants on interest rates — particularly Moore, who has said as much,” noted David Zaring, Wharton professor of legal studies and business ethics, in a separate interview. “Cain has in the past advocated a return to the gold standard, so he might not be as enthusiastic about low interest rates as is the president.”
Wharton finance professor Krista Schwarz is worried about “repeated public interference” in the Fed’s setting of monetary policy, which she said is unprecedented. “The current nominees threaten the nonpartisan nature of the Federal Reserve.”

The seven members of the Board of Governors of the Federal Reserve System are nominated by the president and confirmed by the Senate. They sit on the 12-member Federal Open Market Committee (FOMC) along with five other members, who are presidents of Federal Reserve Banks.

Conti-Brown pointed to “a litmus test” in 2021, when current Fed chair Jerome Powell’s term ends, after which he could be nominated for a second term or replaced. He said that Trump or another president could push to have “a loyalist” in that role. “This idea of rigor in the personnel that are appointed at the Fed is the heart of Fed independence,” he said. “It’s very fragile. It’s very important. For the Republicans, this is the line in the sand they need to draw.”

Conti-Brown appreciated that Cain had been a CEO and served at the Kansas City Fed as well. However, what is “disqualifying” about Cain is that the central bank ideology differs from a partisan ideology, he said. Moore lacks Cain’s experience, and “he’s unequivocally not a good nominee,” he added. “Congress designed the Fed so that partisans can’t use them for electoral ends. And that’s the thing we have to preserve.”

Risks of Doubting Data

When she was a staff economist in the Obama Administration’s Council of Economic Advisers, Cook said she saw Moore, Trump and Cain questioning the Bureau of Labor Statistics and its unemployment data. “I was incensed,” she said. The BLS has “professional, nonpartisan, and very hardworking economists who … are free from political persuasion,” she said. “You can imagine [what could happen] if they’re not protected. A fundamental disbelief in this independent agency producing independent data … mars how the data will be interpreted.”

The risks involved in suspecting the quality of the data while making decisions at the Fed could also have consequences globally. “The Fed’s influence in the world is profound,” said Conti-Brown.

Cook agreed. “In terms of fundamental decision making and using the kind of data that would, say, stem the flow of a financial crisis, that would be bad not just for the U.S. but for the rest of the world.”

The Case for Independence

Schwarz explained why she believes the Fed needs to be run in a nonpartisan fashion. “The credibility of the Federal Reserve, which stems from its apolitical policy approach, strengthens the transmission mechanism of monetary policy and thus its effectiveness,” she said. “Credibility takes a long time to build, but can be quickly destroyed. It is not in either political party’s interest to put this in jeopardy.”

To be sure, the Fed has routinely faced political pressures, said Conti-Brown, who is also a financial historian and author of the 2016 book The Power and Independence of the Federal Reserve. “The Fed is a political institution, but it’s not a partisan institution, and it is indeed influenced by a political process,” he added.

However, previous administration insiders who went on to take up top jobs at the Fed, such as Ben Bernanke (Fed chair, 2006-2014) and Alan Blinder (Fed vice chair, 1994-1996) were experts on economic issues who also shielded their roles at the Fed from partisan politics, Conti-Brown noted. “A baseline of competence, experience and expertise disciplined both Blinder and Bernanke to say, ‘We’re not going to put this midterm or presidential election at the forefront of our monetary policy.’

“A partisan is only asking the question: ‘Is this good for us or bad for us in the next election?’” Conti-Brown continued. “A central banker has to ask the opposite question, which is: ‘Forget elections. Is this good or bad for America?’ Moore and Cain lack that baseline competence to be able to say, ‘the partisan noise is noise. Let’s focus on the short-, medium- and long-term economic effects of these policies for America as a whole.’”

Schwarz said no clear solution exists to insulate the central bank from partisan politics in the U.S. or elsewhere globally. “In many situations, the central bank is the only part of the government that is capable of responding quickly to crises,” she noted. “This puts them in the crosshairs of populist politicians.”

At the same time, there are “many degrees of political meddling,” Schwarz added. “Appointing two unconventional nominees to the Board is probably something that the Federal Reserve System can accommodate, even if it introduces a temporary partisan tone to the policy process.

But, if Trump were then to attempt to fire Powell and replace him with one of his nominees, that would be much worse, and could have a lasting impact on the market’s confidence in the institution.”

Not All the President’s Men

Trump has often stirred controversy in his comments about Fed policy. For example, just last week, he urged the Fed to lower interest rates. “I think they really slowed us down. There’s no inflation. I would say, in terms of quantitative tightening, it should actually now be quantitative easing.”

According to Conti-Brown, Trump’s utterances are hurting the Fed, whether or not it heeds him. “President Trump should never have been making these kinds of noises and criticisms because … the narrative is now about the Fed reacting to the president, and that in itself undermines the Fed’s credibility,” he added. “When you heap political loyalists on top of that pile, then the narrative starts to get shaped in that way because for at least two members of the 12 members voting on the Federal Open Market Committee, that is the lens through which they see the world.”

The ideology of a central banker is one of empiricism and uncertainty, Conti-Brown observed. “A partisan does not truck in uncertainty. The world is always clear — ‘We’re always right, our opponents are always wrong,’ and they don’t deal with nuance.”

Cook noted that notwithstanding Trump’s push for lower interest rates, Powell and others on the FOMC are asking “serious intellectual and scholarly questions” on interpreting economic data before making their decisions. “I don’t think that they are bowing to the pressure of the president. Jay Powell has been somewhat defiant, and that’s a good thing.”

Protecting a Tradition

The longstanding tradition that has preserved Fed independence would be at risk if these two candidates were nominated and then appointed, said Cook. “This could threaten the [Federal Reserve’s] dual mandate of maximizing employment and growth.”

According to Zaring, Trump has “broken with a number of traditions that help to guarantee” central bank independence. “He’s hectored the Fed, had board members to dinner at the White House, and now mused about making these pretty political appointments. I’m not worried yet — the Fed should be able to take a little criticism, the board should absolutely talk to the White House and President Trump’s previous Fed appointments have been beyond reproach.”

What are the likely scenarios? Schwarz expects Cain and Moore to face pushback at confirmation hearings. Zaring predicted that they either will not get nominated, or if they do, they will be confirmed only by voting along party lines. Already, three Republican senators have said they won’t back Cain, and a fourth in opposition “would sink a nomination,” Bloomberg reported.

China’s Auto Market Will Be Hard to Jumpstart

Investors counting on Beijing to reverse the slide in Chinese car sales may be disappointed

By Jacky Wong

A car dealership in Shanghai. China’s auto sales fell for the 10th straight month in April. Photo: Qilai Shen/Bloomberg News 

The world’s largest car market keeps skidding. Investors hoping that Beijing will push it back on track may need to wait a bit longer.

China’s auto sales fell 15% in April compared with the same month in 2018, the 10th consecutive month of decline and worse than the 11% drop recorded in the first quarter. That’s even after a cut in value-added tax last month prompted many car makers to reduce prices. Inventories on car lots have also picked up after dealers ran them down in the first quarter.

Actual demand may be a bit better than the numbers indicate, as some potential car buyers may be waiting for a more-targeted stimulus. A draft document from China’s top policy planner last month outlined policies that would benefit the auto sector specifically, including a cut in purchase taxes for rural residents and looser restrictions on license plates in major cities.

What eventually gets implemented, however, could be different from the draft. An auto stimulus may not give Beijing much bang for its buck: Citi estimates that a 5 percentage-point increase in the rate of auto sales growth would only boost China’s real GDP by 0.2%. That suggests the government is better off focusing its efforts on infrastructure investments or shoring up exports.

Of course, if the continuing trade conflict with the U.S. drags on into the second half of the year, Beijing may eventually have to pull out all the stops, including more tax breaks for car sales, to steady its economy. But it will be hard to match the impact of previous stimuli. The last tax break, which ended in 2017, brought forward sales, shrinking the pool of potential car buyers.

The current market shakeout will be particularly tough for local manufacturers. Many global auto makers are launching new models in China this year: General Motors ,for example, plans to release 20 new and refreshed models. Foreign brands tend to have a better reputation for quality among Chinese consumers, and are also priced competitively.

After a strong rebound at the beginning of the year, Chinese auto stocks have drifted back down, but it’s too early to jump aboard. Even if Beijing does give the industry a break, fierce competition will impose a speed limit.