The US Federal Reserve kept the federal funds interest rate steady at 5.25 percent on May 9, maintaining the rate in place since last June.

 

This is the seventh time that the US central bank has decided to leave the interest rate at its current level since August 2006. The Federal Open Market Committee explained its decision in a regular open statement.

 

The federal funds rate decided by the Federal Reserve is only a short-term bench-mark interest rate. The long-term interest rate, which is set by market supply and demand as well as market speculation on the national economy, is an index of more importance.

 

Currently, the 10-year treasury bond has a yield of 4.67 percent, far below the federal funds rate. This unusual difference in the long-term and short-term interest rates is solid proof that the market holds a conservative view about the US economy.

 

The view comes from worry that the double deficits in the US current account and the national budget are obviously not sustainable and a major policy change will be inevitable sooner or later. After all, the US government will not sit idly by doing nothing to prevent the double deficits' deteriorating into a recession.

 

A policy change in the US, the world's leading economy, will definitely have a global influence, especially on policy-making in other economies.

 

If the US raises its interest rate, countries targeting a capital account surplus will have to raise their own interest rates to keep attracting the international capital.

 

Thus, these nations are losing part of their control over the interest rate, a major economic policy tool.

 

As an emerging country in the midst of an economic boom, China is gaining an increasingly important position in the world economy.

 

But its economy is not comparable to the US in GDP volume, per capita income, the maturity of its capital market, or the establishment of a market economy. Nevertheless, the Chinese economy is further integrating into the global community.

 

Therefore, a major policy adjustment in the United States will have significant influence on the Chinese economy as well as the capital market here.

 

The US Federal Reserve will probably cut the federal funds rate repeatedly in the case of a sudden slump in US economic growth or an increasingly gloomy housing market. Then large sums of capital eyeing short-term revenue will flow out of the US. China would be an ideal hub for this money.

 

China is seeing an excessive liquidity and price hikes in capital assets. The authorities should have increased the interest rates of the yuan as a countermeasure. However, once the rate is raised, the interest difference between the Chinese deposits and the US federal funds would be narrowed, which would only attract more inflow of capital.

 

Moreover, a narrowed interest difference between China and the US would also add more pressure to appreciate the renminbi. This goes against the wishes of the Chinese monetary authorities to keep currency appreciation steady and gradual.

 

In other words, the changes in the US federal fund rate will limit the room of the Chinese authorities in running the economy by adjusting the interest rate.

 

Besides the interest rate, the US government will also resort to depreciating the US dollar as a means of tackling the double deficits, especially the deficits in the current account. The US decision-makers will probably prefer this over raising the interest rate. After all, the dollar depreciation would recover the international balance more effectively.

 

The People's Bank of China, the central bank, will have to maintain the exchange rate between the renminbi and the US dollar at the level it wants when the dollar softens.

 

China and other East Asia countries will witness increased inflow of international capital, swelling their foreign exchange reserve and lifting their capital price.

 

The tide of money inflow will recede only after the US dollar picks up, leaving the East Asian countries a shrinking surplus or even deficits in the capital account.

 

There has already been a huge sum of hot money in China after the high yield in the capital market. This money is unlikely to be withdrawn from the capital market because of the change in the interest rate difference. The inflow of the global capital into China is not going to suffer from the US interest rate change.

 

On the other hand, if the US dollar depreciates, the flow of international money in and out of China will certainly cause dramatic fluctuations in China's capital market.

 

However, the soaring stock prices are primarily driven by internal factors, not foreign capital. And most of the foreign capital here operates through hedge funds.

 

Therefore, neither the interest rate cut nor the US dollar depreciation is going to change the natural cycle of the Chinese capital market.

 

To sum up, the changes in the US monetary policy and the exchange policy will both restrict the room of the Chinese authorities in manipulating the domestic economy with policy tools. They would also cause fluctuation on the capital market though the natural cycle of the market may not be altered.

 

Hence, forecasting the US policy change is an indispensable element for policy-making here.

 

The author holds a PhD from the Institute of World Economics and Politics under the Chinese Academy of Social Sciences

 

(China Daily May 17, 2007)