The move to a more free floating CNY (for details see FX Strategy: China's big bang: CNY devaluation and market implications , 11 August) has caused a close to 3% depreciation of the CNY against the USD, with ripple effects across the rest of Asia. This prompts the question of whether the shock to the effective USD exchange rate is enough to keep the Fed from hiking in September. Markets are now pricing a little less than 40% probability of a September rate hike and a first hike is not fully priced until the January FOMC meeting next year.
Looking at the pure impact on the US from the depreciation of the Asian currencies over the past month, the macroeconomic impact should so far be limited . Overall, the move in the CNY and other emerging market Asia exchange rates over the past three months has led to a total increase in the nominal effective USD exchange rate of 5.5%. The negative GDP impact of this move is around 0.5% over the coming two years if we use the rule of thumb (consistent with the Fed's FRB/US model) that a sustained 10% appreciation of the effective USD gives a drag on GDP of 1% over two years. The risk is that the People's Bank of China (PBoC) allows the currency to depreciate at a continued rapid pace over coming weeks but this is not our base case. In terms of the timing of the first hike, we thus believe that domestic economic data released over the coming month will be more decisive for the Fed . The July retail sales data released tomorrow is the first in line. So far, we stick to our view that September is the most likely month of lift-off but with a risk the hike will be postponed to either the October or the December meeting.
The new regime from the PBoC does have the potential to influence the pace of Fed hikes . This really depends on how much the PBoC will eventually allow the currency to depreciate and on the pass through to the rest of emerging market Asia FX rates. With the Fed now 'on its own' after China joining the global currency war, the impact on monetary conditions from a given increase in the fed funds rate is, all else being equal, likely to be larger . This implies that the Fed could engage in an even slower rate hike cycle than our current expectation of 100bp per year. However, it is premature to change our forecast for the Fed funds rate path at this stage, as uncertainty remains high.
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