[US]The Fed's Steep Rate Hike: Causes, Shocks and Responses
Zhang Ming, Research Fellow, Doctoral Supervisor, Deputy Director of the Institute of Finance, Chinese Academy of Social Sciences, Deputy Director of the National Finance and Development Laboratory
Note: On 22 March 2022, the author published an opinion piece in People's Daily titled "Background, Shocks and Responses to the Fed's Interest Rate Hike". In the past three months, the evolution of events has basically been in line with the author's judgment in this article. In response to media requests, I have updated the above article. Please ensure that the source is acknowledged.
Since the outbreak of the epidemic in early 2020, the US government has implemented extremely accommodative fiscal and monetary policies to bail out the market. On the monetary policy side, the Federal Reserve has cut the federal funds rate to 0-0.25% in a very short period of time and implemented a massive quantitative easing policy, expanding the Fed's balance sheet from US$4 trillion to US$9 trillion. In terms of fiscal policy, the US federal deficit reaches 15% of GDP in 2020 and the main stimulus is direct monetary assistance to low and middle income households.
Driven by massive fiscal and monetary stimulus, the US economy recovered rapidly from the recession caused by the epidemic. In terms of the labour market, the unemployment rate in the US was 3.6% in March, April and May 2022, close to its lowest level ever. In terms of inflation, the US CPI and core CPI growth rates reach 8.5% and 6.0% respectively in May 2022, well above the Federal Reserve's monetary policy target of keeping average core inflation at around 2%.
The main reasons for the high inflation rate in the US include: from an internal perspective, the current economic growth rate exceeds the potential economic growth rate, the domestic consumption recovery is ahead of the production recovery and high tariffs have been imposed on some imports originating from China; from an external perspective, the outbreak of the Russia-Ukraine conflict in late February 2022 has caused a new supply-side shock to the global commodity market, resulting in commodity prices, represented by crude oil and food soared, creating imported inflationary pressures on the US.
On 16 March 2022, the Fed raised interest rates by 25 bps. on 4 May, the Fed raised rates by 50 bps. on 15 June, the Fed announced another 75 bps rate hike. Such a tight pace of rate hikes and such a steep increase in rates has not been seen since the first half of the 1990s. In addition, the Fed also announced that it would begin tapering its assets by US$95 billion per month from June.
Whenever the Fed enters a sustained cycle of interest rate hikes, it is often a day of turmoil in international financial markets. Long-term interest rates in the US have climbed significantly over the past six months or so. Recently, the yield on the 10-year US Treasury note once approached 3.5%. As the most important pricing benchmark for global financial markets, rising long-term US interest rates will depress the prices of global risk and safe-haven assets and push the US dollar up significantly against other currencies (the US dollar index has recently risen to around 105). However, in some cases, a Fed rate hike will primarily lead to financial turmoil in emerging markets, while at other times, a Fed rate hike will result in increased financial turmoil of its own.
On the one hand, the Fed had continued to raise interest rates several times before the Latin American debt crisis of the 1980s and the Southeast Asian financial crisis of 1997 to 1998. As the Fed enters the interest rate hike cycle, the interest rate differential between the US and emerging market countries usually narrows, which is likely to lead to short-term international capital flowing back to the US from emerging market countries. In this scenario, emerging market countries would typically face a dilemma of falling domestic asset prices, depreciation of the local currency against the US dollar and rising pressure on foreign currency debt. If they do not respond properly, a currency crisis, debt crisis, financial crisis or even economic crisis may break out. In addition, when the Federal Reserve announced in 2003 that it would consider ending its easy money policy, it also triggered financial turmoil in some emerging market countries.
Notably recently, the Japanese yen has plunged against the US dollar. The yen has recently fallen to around 135 yen per dollar against the US dollar. The sharp fall in the yen against the dollar could have a negative impact on some export-oriented emerging market economies with a more similar trade structure to Japan, and could even trigger a chain reaction of depreciation of the currencies of these emerging market countries relative to the dollar.
On the other hand, before the bursting of the US internet bubble in 2000 and the bursting of the US house price bubble in 2007, there had also been multiple interest rate hikes by the Federal Reserve. The logic behind this is that if the valuation of the US domestic capital market or real estate market significantly exceeds a reasonable level, then as the Fed enters into an interest rate hike cycle, domestic borrowing costs will rise significantly, which will also depress domestic valuation levels and lead to a significant decline in asset prices, thus triggering a financial crisis. Apart from 2000 and 2007, the Fed's successive interest rate hikes from 2015 to 2017 had also led to a fall of around 20% in the US stock market in 2018. Since the start of the year, several major US stock market indices have fallen by more than or close to 20% from their yearly highs, a technical bear market criterion. Volatility in US equities is likely to remain at high levels during the year, and the possibility of a significant decline cannot be ruled out.
So, will this round of Fed rate hikes in 2022 significantly hit emerging market countries or the US financial markets themselves? The answer is not yet clear. However, given the intertwined nature of this Fed rate hike and the Russia-Ukraine conflict, it is likely that these two shocks will lead to a renewed challenge of stagflation in the global economy. The impact of the extremely steep Fed rate hike cycle on both emerging markets and the US financial markets will not be small.
How should emerging market countries, including China, respond? First, against the backdrop of intensifying external shocks, emerging market countries should do everything possible to maintain stable domestic economic growth, as sound domestic fundamentals are the primary prerequisite for resisting external shocks; second, emerging market countries should avoid running large current account deficits, which usually lead to strong depreciation pressure on the local currency; third, emerging market countries should allow the exchange rate of the local currency to be more flexible against the US dollar. Fourthly, emerging market countries should retain appropriate capital flow controls to prevent a vicious circle between large capital outflows and the expected depreciation of the local currency; Fifthly, emerging market countries should prepare for the crisis and be prepared for it.