Two of the fundamental factors that influence the Federal Reserve in its decision making with regard to the question of whether conditions are right for an interest rate hike, and if so, when they should start moving the rate upwards, are employment and inflation numbers.
The devaluation of the yuan could well prove to be a big stumbling block in the way of the Fed’s intentions to normalize its monetary policies. Amongst other factors, a devalued yuan means imports from China will cost less, and the knock on effect of cheaper imports will be slower growth in the U.S. economy, reducing the potential for lowering the unemployment rate further.
The Fed has repeatedly said that they need to see continuing improvement in the labor data and evidence that inflation is approaching the target of 2% before a rates hike can be implemented. The devalued yuan could delay any action by the Fed in the short term.
One of the major issues in global trading markets has for some time been the low cost of goods coming out of China. Part of the reason is the traditionally low wages paid in China together with very few restrictive laws, such as those regulating air pollution and other environmental issues that add to production costs elsewhere.
One of the major reasons for cheap Chinese goods, however, is the low value of its currency, the yuan, in world financial markets. While market forces decide the value of currencies, there are some that have controlled values.
The Chinese yuan is one of the currencies that does not float, but has its value is tied to the U.S. dollar (USDCNY, -0.0234) at a level below its proper value. The reason given by the Chinese government for its policy of not allowing the yuan to float is to allow its export sector to grow.
During May, when one U.S. dollar cost 6.20 yuan, the International Monetary Fund said it no longer saw the yuan as being undervalued. The current rate of around 6.40 yuan for one dollar means therefore that the currency is now at least 3% below its real value, a very conservative number, in the opinion of many economists.
Irwin Kellner says that there are two primary reasons for China to have weakened an already weak currency.
The first is that the Chinese economy is struggling and needs a boost, and secondly, tied to a dollar that has strengthened against most other currencies, the yuan has followed suit and risen in value against the currencies of its trading partners. A hike by the Fed would disadvantage the yuan even further.
The other effect that will be felt in the U.S., according to Keller, is that wealthy Chinese have been taking money out of the country to purchase homes in the U.S., pushing up the price of luxury homes in good areas, often offering to pay cash. A lower yuan will discourage some of this activity and if the yuan is allowed to drop further, luxury purchases in the U.S. could be dampened even further.
The devaluation of the yuan may well stay the hand of the Fed in hiking interest rates, considering that most other central banks are loosening their monetary policies.