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It is an exciting time to be a macro analyst. Equity markets are clearly not driven by fundamentals. Rather, they are driven by hopes and misunderstanding of central bank policies. Hopes of stimulative policies drive rallies, and failure to implement them causes sell-offs. In fact, central banks are driving policy so much right now that a downward revision in growth and inflation in China prompted a rally based on hopes of stimulative market intervention by the People's Bank of China.

Confusing Policy Implications

The People's Bank is probably the most confusing central bank in the world because Chinese politics is remarkably opaque due to a cloistered inner circle of decision makers. Confounding matters is the fact that the People's Bank essentially targets growth the way many central banks target inflation. Growth is an outcome variable, so it is much further downstream than inflation, and it includes significantly more inputs beyond the control of central bank policy. Nevertheless, the People's Bank does have a huge impact on the Chinese economy.

Today, China announced that its economic growth had slowed considerably, and that inflation has gone from over 6% a year ago to down around 2%. This is a rapid drop in inflation that indicates growth may be slowing much faster than previously projected. This reduction in growth and precipitous drop in inflation leaves the door wide open for Chinese economic stimulus. Never mind the fact that reduced growth in China is still in the 7 percent range (at least three times that of the U.S.). That does not meet Chinese expectations and desires for widespread industrialization. So, the market reacted by assuming the Chinese central bank will step in with some form of stimulus.

Since China has experienced solid growth throughout the crisis and recession, its stimulus could still be a simple reduction in interest rates. This would satisfy investors seeking more liquidity in Asian markets, but it could reignite fears of a weak Chinese currency in relation to the U.S. dollar. Sure, this keeps Chinese goods cheap for U.S. consumers, but it also makes U.S. goods more expensive for Chinese consumers (and comparatively, U.S. goods would be pricier than Chinese made goods for consumers around the world as well). This means that significant action to loosen monetary conditions in China could harm U.S. exports and halt our meager manufacturing recovery in its tracks.

Conclusion

We now live in a paradoxical world where slowing growth is a good indicator for markets because they assume central bank intervention. So, markets saw weaker Chinese growth and slowing inflation as a sign of an impending stimulative intervention by the People's Bank of China. The trouble is that the markets seem to forget the currency and trade implications of central bank actions. Should we actually see the People's Bank intervene in China, it could be a very bad sign for the U.S. manufacturing and labor markets,

Source: Another Central Bank Driving Markets