In an annual review and prospect report about the global economy at the beginning of 2018, we said that subject to the repatriation pressure from financial asset prices and tax reform, the US Federal Reserve will raise interest rates more times than the market was expecting -- at least four times. We were right.

Now that it faces the dilemma of “credit or price”, the Fed is expected to slow down the interest rate increases throughout the year, and it will probably raise interest rates only twice, or possibly only once, during the year.

Meanwhile, the central bank of China is expected to continue its 2018 monetary policy this year, and structural easing will still be the theme of that policy.

With the United States slowing down its pace of interest rate increases and China keeping on its structural easing, the differentiated US and Chinese monetary policies are expected to converge in 2019.

Prudence of the Fed

To strengthen the expectation of dollar assets, hedge inflation expectation and prevent the bursting of asset bubbles, the Fed raised interest rates in March, June, September and December 2018, 25 basis points each time, showing a prudent attitude toward interest rises.

The financial markets, however, are increasingly questioning the Fed's decision to raise interest rates.

The interest rate hike process since 2015 has increased the borrowing costs of the public sector, commercial banks, residents and companies. With the decline in the growth rate of repatriated overseas capital, a negative impact on asset prices has emerged. The most direct manifestation is that the price of risky assets, including stocks, has dropped from a high level.

The Fed has less and less room to maneuver between the "interest rate trap" and "asset bubble" in 2018. Now, if it chooses to slow rate rises, the money flowback to the United States will shrink or even stop, and then the dollar index will fall sharply and all dollar-denominated assets, such as stocks, bonds and real estate, will face repricing, and high asset prices will fall, which will affect debt sustainability and the economic recovery might be terminated.

If the Fed maintains the speed and scale of interest rise, financing costs will inevitably rise, too, challenging the sustainability of the US government, companies and individuals that rely on debt financing. Without the support of debt financing, the stock market supported by buybacks will surely slump, and the price of financial assets supported by market capitalization will need to be reassessed. Thus, a new debt crisis will break out, and economic recovery will be terminated.

In a word, whether interest rates are raised or not, the US economy faces a huge test this year, and this is determined by the nature of its debt-fueled growth. Although the Fed’s attitude towards raising interest rates is vague, fewer rises in the future will be of high probability.

Continuing policy

Under the pressure of economic downturn, Chinese monetary policy tightened before easing last year. China responded to the United States’ continuous interest rises in the first half of 2018 by maintaining its policy continuity to some degree. Although China did not raise the benchmark interest rate, it hedged the impact by lowering the required reserve ratio, expanding the collateral range of Medium-term Lending Facility and launching new Targeted Medium-term Lending Facilities to ensure sufficient funds in the currency market.

In 2019, China’s monetary policy may continue to be structural easing, but overall quantitative easing is not likely to happen. There are three reasons for this.

First, the external pressure is smaller. As the Fed’s rate rise slows down, the emerging markets face less pressure on exchange rates and capital flows, leading to a relatively loose external environment for easy monetary policy.

Second, since the latter half of 2018, China’s monetary policy has been relatively loose, and the policy needs to be further observed, so the chances of large-scale easing are slim.

Third, the crux of the problem lies in the sluggish profit creation of enterprises, especially the private ones. Easy money in a highly regulated market environment is unlikely to flow significantly into those high-risk, low-yield areas. “Targeted” structural easing is likely to be the main direction.

The author is a researcher at Taihe Institute and a researcher at the International Monetary Institute, Renmin University of China. The author contributed this article to China Watch exclusively. The views expressed do not necessarily reflect those of China Watch.

All rights reserved. Copying or sharing of any content for other than personal use is prohibited without prior written permission.