US Federal Reserve’s attempt to turn inflation tide leaves Asian economies exposed

Comparisons between circumstances today and the run-up to the Asian financial crisis of 1997 should not be overemphasised
However, a combination of aggressive Fed tightening, a potentially even stronger dollar and pronounced yen weakness could prove problematic for those carrying US dollar-denominated debt

Neal Kimberley

Published: 12:30pm, 21 Jun 2022

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The US Federal Reserve is off the bench and back in the game – finally. Last week’s decision to raise US interest rates by 0.75 percentage points was a major step towards restoring the Fed’s credibility as an inflation fighter. This will have global ramifications, not least in Asia.

The Fed prepared the ground well for its biggest single rate hike since 1994. Until just days before the announcement on June 15, markets had anticipated a rise of 50 basis points, but after some deft communication from the US central bank, markets recalibrated towards the idea that a 0.75 percentage-point increase was coming.

But what’s also critical is that rate-setters now expect the benchmark Fed funds rate to be substantially higher at the end of 2022 than they had envisaged in March.

June’s projected median policy path now foresees the rate at 3.4 per cent at the end of the year, significantly higher than March’s 1.9 per cent prediction. That means there will be a succession of US interest rate rises this year, with the Fed meeting again on July 26-27.

At the same time, the Fed downgraded its expectation for US gross domestic product growth in 2022 to 1.7 per cent from March’s 2.8 per cent projection. The Fed is now prioritising driving down inflation and is prepared to tolerate a slower pace of GDP growth as a consequence.

In Hong Kong, with its linked exchange rate system, the Monetary Authority increased its base rate by 0.75 percentage points last Thursday. More hikes will follow as the Fed further tightens US monetary policy.

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US Fed raises interest rates by 0.75 percentage point, the biggest hike since 1994

While there is always the possibility that American demand for Chinese goods could be adversely affected by the combination of existing US inflationary pressures and tighter Fed monetary policy, China’s economic heft provides quite a cushion.

Indeed, even with the Fed now in full tightening mode, the needs of the Chinese economy mean the People’s Bank of China is likely to persevere with its stable-to-looser monetary policy settings.

Whether the currency markets conclude that this China-US monetary policy divergence justifies renewed yuan weakness versus the US dollar remains to be seen, but elsewhere in Asia the calculation may be easier to make.

Other central banks, such as the Swiss National Bank, are also in hiking mode but not the Bank of Japan. The Japanese central bank seems determined to use the recent uptick in global inflationary pressures, also evident in Japan, to eradicate a long-established and deep-rooted deflationary mindset.

Friday saw the Bank of Japan recommit to its yield curve control policy of keeping the yield on the benchmark 10-year Japanese government bond close to zero, reiterating its determination to purchase an unlimited amount of 10-year Japanese government bonds at 0.25 per cent in pursuance of that objective.

The market’s reaction to the pronounced divergence in monetary policy between the US and Japan has already played a major role in driving the yen to a 24-year low against the US dollar. The fact that the Fed will continue raising interest rates while the Japanese central bank remains wedded to controlling the yield curve may only exacerbate the situation.

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That leaves a lot of other Asian countries in a quandary. Even as the Bank of Japan persists with yield curve control, with inflation in South Korea at a 13-year high, the Bank of Korea raised interest rates to 1.75 per cent last month and emphasised that its “policy focus will be on price stability for some time”.

But, if the Bank of Japan does stick with yield curve control and the Bank of Korea tightens monetary policy further, this could also translate into a yet stronger Korean won versus the yen, a prospect that would not play well with South Korean exporters that vie for business globally with competitors in Japan.

An employee at a currency exchange hands a stack of 10,000 Japanese yen banknotes to a customer in Hong Kong on June 15. Photo: Bloomberg

Additionally, while comparisons between circumstances today and the run-up to the Asian financial crisis of 1997 should not be overemphasised, no one should underestimate the risk that a combination of aggressive Fed tightening, a potentially even stronger dollar and pronounced yen weakness could prove problematic for those carrying US dollar-denominated debt who then find they lack the wherewithal to service it.

With the Fed determined to turn the tide of US inflation, billionaire investor Warren Buffett’s famous quote bears repeating: “Only when the tide goes out do you discover who has been swimming naked.” The world may be about to find out who has been skinny-dipping.

Neal Kimberley is a commentator on macroeconomics and financial markets