The Fed, China and More Upset the Markets

The global economy and investment markets are being roiled by policy actions in the three largest economies. Japan is the third-largest economy and the largest nondomestic holder of U.S. Treasury bonds, when both private and public sector holdings are considered, owning $1.3 trillion in treasuries.

The Bank of Japan continues to try to stimulate its sluggish economy while the U.S. Federal Reserve tightens monetary policy. The conflicting policies drove the yen to its lowest level against the dollar in at least 20 years. The plunging yen makes it expensive for Japanese life insurers and other inves- tors to hedge potential currency losses on their U.S. assets.

Plus, the Fed’s determi- nation to continue raising interest rates makes treasury bonds a bad investment for now. The result is Japanese investors sold $60 billion of treasuries in the three months through the end of April and aren’t partic- ipating in auctions of new treasuries.

The marginal selling is a major reason U.S. interest rates increased rapidly in 2022 though the Fed barely began to tighten monetary policy. China, the second-biggest economy, is making a wide range of rapid policy shifts.

You might recall that in 2021 China’s leadership made significant changes in the economy, markets and culture. It cracked down on technology and other industries in several ways. Policies were adopted to reduce real estate investment and boost manufacturing and other sectors of the economy.

Efforts also were made to in- crease domestic demand and move China away from an export-oriented economy. Recently, however, the government slowed, paused or suspended many of these measures.

The damage to the econ- omy and markets was more than leaders anticipated. In addition, because of China’s zero-COVID-19 pol- icy, all activity in some major cities and regions ceased re- cently because of an outbreak of COVID-19 cases. China’s economic growth now is the slowest in years and is unlikely to return to pre-2020 growth rates.

Some analysts say this is Chi- na’s version of a recession, though reported growth still is positive. The negative effects of these policies spread from China to the global economy. There’s reduced demand for many commodities because demand from China is down. The rapid increase in commodity prices we saw early in 2022 slowed.

In addition, with about 20% of China frozen to stop the spread of COVID-19, production and exports are down, greatly exacerbating the global supply problems until China re-opens those areas and resumes production. China has taken some measures to increase growth, but they’re modest and will take time to work. In the United States, investors finally are taking seriously the Fed’s commitment to bring inflation back to its 2% target. Financial markets are the first to react to interest rates changes.

That’s why stock and bond prices fell well below their 2021 highs even before the Fed took serious action. Housing sales also fell.

The Fed and investors were betting in- flation would decline rapidly after mod- est tightening, avoiding the potential the Fed would have to tighten enough to cause a recession. But domestic demand remains strong, and the labor market is as strong as it’s ever been. A shortage of workers leads to higher wages, which maintains demand for goods and services despite higher prices. Shortages of goods and labor make it unlikely businesses can increase pro- duction to meet demand any time soon.

Consumers have to pay higher prices for the goods and services they really want or need. Households can’t consume more despite earning and spending more. While the inflation rate probably is at or near its peak, significant reductions in demand are needed to bring it to the 2% target.

Until the Fed takes more significant actions, economic growth will steadily slow while inflation remains sticky.