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The Trajectory of the Dollar and its Impact on RMB Internationalization

Recently, the RMB has remained weak against the dollar. Even though the IMF deemed the RMB a freely usable currency and recommended it be included in the SDR basket, this favorable assessment did not reverse the weakness of the RMB. The depreciation of the RMB against the dollar has been largely due to dollar strength, which in turn resulted from expectation of the Fed hiking interest rates in December and Euro weakness. Looking ahead, as the dollar is likely to strengthen moderately, the exchange rate of the RMB may continue to be pressured, and RMB internationalization will be faced with new challenges.

I. A Fed rate hike in December almost a done deal

The U.S. economy continues to recover moderately and in 2015 will probably grow at a pace of 2.5%, slightly stronger than the 2.4% growth rate in 2014 and an average of 2.28% since the end of the financial crisis. In October, 2014, the Fed began to tighten monetary policy by terminating QE3. However, the Fed funds rate remained between 0% and 0.25%. In order to mitigate the distortion on financial markets caused by 7 years of zero interest rate policy, interest rate normalization should not wait any longer. Based on the following rationales, a Fed rate hike in December is probably a done deal.

First, the labor market’s performance is one of the two policy goals of the Fed. In October, the U.S. non-farm payroll increased by 271,000, far greater than the consensus forecast of 185,000. Meanwhile, the unemployment rate dropped to 5%, a level considered full employment and a 7.5-year low. Overall, the U.S. labor market is clearly improving.

Second, inflation, another key factor in the Fed’s decision making, will likely trend upwards. In October, CPI and core CPI rose 0.2% and 1.9% compared with the same period last year, lower than the Fed’s 2% target. Among the components of CPI, shelter related costs account for about 42% of the weight, and home prices and rents continue to rise. More importantly, average hourly wages in October rose 0.4% compared to a month ago and 2.5% compared with the same period last year. Rising wages will translate into inflationary pressure soon.

Third, the Fed must initiate rate hikes to protect its credibility. The Fed has been strongly hinting at raising interest rates by the end of the year. The prospect of rising interest rates caused turbulence in global financial markets in August and September. However, given that domestic consumption remains a key driver of the U.S. economic recovery, the Fed will have to fulfil its promise and raise the Fed funds rate at the last FOMC meeting of the year.

Four, the majority of FOMC members support a rate hike. Prominent and influential figures such as Vice Chairman Fischer, New York Fed President Dudley have publicly called for early and gradual rate hikes.

Five, in the futures market, the implied probability of a December rate hike has soared to over 70%. Some institutional investors have begun to rebalance their portfolios, reducing their treasury holdings and buying dollars. Financial markets and the Fed appear to be on the same page.

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Content provided by Bank of China (Hong Kong)
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