Not only has the People’s Bank of China (PBoC) not followed in the Federal Reserve’s rate hike footsteps (rather, it began publishing an index of the renminbi (RMB) measured against a trade-weighted basket of currencies—instead of just the dollar—prior to the Fed’s meeting), but it also continues to use a markedly different strategy with respect to forward guidance. The PBoC set a stronger reference point on December 21st for the RMB exchange rate against the dollar for the first time in 11 trading days despite market expectations of further RMB weakening and continued PBoC commitment to liberalizing the capital account. This move was likely to prevent one-way bets on the currency’s depreciation from materializing into a self-fulfilling prophecy and fueling rapid, destabilizing capital outflows; thus, the PBoC can continue to pursue liberalization goals.
The PBoC is maintaining its ability to surprise financial markets. While this can lead to destabilization (as with the sudden RMB devaluation in August), it can also retain some freedom for the PBoC and instill some caution in market players. While the Fed tried to broadcast its move well in advance so there would be gradual market adjustment ahead of the Fed’s move, it backed itself into a must-hike corner. When instability arose in the summer, the Fed was forced to postpone its well-broadcasted September liftoff—leaving it with little choice but to hike at its December meeting if it wanted to maintain its credibility—despite the drag of the dollar’s appreciation, weak inflation and wage growth numbers, and the specter of secular stagnation.
A new danger comes from market actors thinking they know what the Fed will do at its policy meetings.
Similarly, across the pond, the President of the European Central Bank (ECB), Mario Draghi, had been reinforcing that the ECB will do whatever it takes to return the eurozone to inflation. Thus, the market expected more easing measures of him at the last ECB governing council’s meeting than he could deliver without the political support of his fellow council members. Markets went into temporary tumult when he didn’t live up to these expectations.
While the Fed delivered its implied rate hike at its December 16th meeting to maintain its credibility and Draghi’s dovish comments proved stimulative in their time, central banks may have actually lost the tool of the ability to “credibly promise to be irresponsible” as a means to return inflation and inflation expectations to their 2% targets, a policy tool that the PBoC has managed to retain.