TOKYO – It’s safe to say Jerome Powell had Asia investors at “wait.” Markets in the region rallied on cue Wednesday as the Federal Reserve chairman made clear that rumors of an imminent US interest rate tightening were greatly exaggerated.
“We will wait for evidence of real inflation or other indications,” Powell, who argues the recent inflation scare is “transitory,” told US lawmakers.
That, notes economist Shane Oliver at AMP Capital, means the type of sudden Fed tapering Asian markets fear is “still a long way off, because even the first rate hike is still a long way off.”
Yet a destabilizing inflation surge might not be far off at all. The Fed losing control of consumer prices could devastate markets everywhere. In all past US inflation cycles, eventual Fed tightening led to recessions, often deep ones.
And at the moment, a dearth of business investment to drive innovation and productivity suggests any US recovery stands on soft underpinnings.
This, not surprisingly, is creating a rift in Fed policymaking and investment circles.
John Williams, president of the influential New York Fed, seems to be in Powell’s inflation-is-transitory camp. In a Bloomberg interview, Williams said significant moves to taper the Fed’s massive bond-buying program are “still way off in the future.”
That’s quite a contrast from what markets are hearing from Dallas Fed President Robert Kaplan, who favors a policy shift “sooner rather than later.” Or St Louis Fed leader James Bullard, who calls it “appropriate” for policymakers to debate whether Covid-era stimuli should be curtailed.
“No one really knows how this is all going to unfold,” Bullard said this week. “We have to be ready for the idea that there is upside risk to inflation and for it to go higher.”
Added Kaplan: “I think we’d be healthier, as we’re making progress in weathering the pandemic and achieving our goals, to start adjusting these purchases – Treasuries and mortgage-backed securities – sooner rather than later.”
Some top investors, including Ray Dalio, fear the Fed is falling behind the inflation curve.
“It’s easy to say that the Fed should tighten, and I think that they should,” says the founder of monster hedge fund Bridgewater Associates. “But I think you’ll see a very sensitive market, and a very sensitive economy because the duration of assets has gone very, very long.”
That has some in Asia uttering the S-word.
“Is the US approaching a stagflation surprise?” ask Citibank Asia analysts in a recent report. They warn that the bank’s Economic Surprise Index “is teetering on the brink of negative territory” as prices revive faster than gross domestic product (GDP).
The problem for Asia, should US inflation take off, is the balancing act it presents for governments. On the one hand, aggressive Covid-era stimulus efforts are fueling froth in asset markets and goods prices. On the other, a US recession confronts Asia with a major downside risk – and limited latitude to respond given that fiscal and monetary space is now quite limited.
Going forward, “we must prepare for possibilities of the US central bank, the Fed, to shift its monetary policy, reducing its liquidity intervention,” Bank Indonesia Governor Perry Warjiyo said earlier this month.
Reserve Bank of India Governor Shaktikanta Das says he’s on the watch for “global spillovers” from Washington and adding to foreign currency reserves, which now top US$600 billion.
In Manila, Bangko Sentral ng Pilipinas Governor Benjamin Diokno is also watching Washington closely, but doubts any action in short order. “In any event, an increase in interest rate in the US is not an immediate threat to the Philippines because we have a lot of tools that will address that concern,” Diokno says.
“The Fed chairman committed to keeping interest rates low for a long time, right? At the earliest 2023 – could be longer depending on the crisis.”
Any weakness or turmoil in the globe’s biggest economy would greatly complicate Asia’s trajectory over the next six to 12 months. At present, says Ryan Sweet at Moody’s Analytics, all markets can do is hope the Fed knows what it’s doing.
Generally, he says, projections show “two rate hikes in 2023, but it’s hard to glean how aggressive this tightening cycle will be, as it hinges on how much of an inflation overshoot the Fed will stomach.”
Even so, Asia doesn’t appear as paranoid today about Fed tinkering. What’s tantalizing about the drama surrounding the world’s most powerful central bank is how little panic one senses. Whereas the Fed “taper tantrum” of 2013 was a financial earthquake of sorts, such chatter in 2021 is proving less seismic.
Among explanations why, three in particular stand out.
One is a bet the Fed might be right that the 5% surge in US consumer prices in May year-on-year will pass. Two, a focus on Japan’s 20-year struggle to normalize interest rates that suggest the Fed is more trapped than Team Powell realizes. Three, a belief Asia’s fortunes are now hitched more to China than the US.
The first dynamic is almost impossible to assess and strategize, partly because the globe has never been here before. It hardly seems surprising, though, that 12-plus years of ultraloose monetary policies everywhere and 18 months of turbocharged Covid-19-era fiscal laxity colliding with supply-chain dislocations and pent-up demand as economies reopen would generate inflation.
As the world reopens, prices of almost everything across sectors are surging amid historically accommodative monetary and fiscal policy. Trade wars and political populism running amuck are also upending supply chains.
This means inflation pressures are coming from both sides – from surging demand and limited supply simultaneously.
The good news is that developing Asia internalized the lessons from the region’s 1997-98 financial crisis. The clearest sign is foreign exchange reserves at the highest levels since 2014 – $5.82 trillion (or a still healthy $2.6 trillion when you strip out China).
Even so, the sense of calm emanating from Fed headquarters in Washington is surprising as the costs of everything from commodities to new home sales to financial assets soar. Hence the rift in Fed policymaking and investment circles.
The market sensitivity to which Dalio referred explains why exploring the lessons of Japan are the rage in Asia these days.
It was back in 1999 when the Bank of Japan became the first major central bank to cut rates to zero. Two years later, then-governor Masaru Hayami pioneered quantitative easing. Twenty years on, the BOJ is still trapped in QE-ville.
Its balance sheet is now beyond anything Hayami’s team could’ve imagined in 2001 – more than double the size of Japan’s $5 trillion annual GDP.
The BOJ tried its hand at tapering in 2006 and 2007 – even executing two 25-basis points rate hikes. The howls of protest from politicians, bankers and businesspeople browbeat the BOJ back to zero and re-embracing QE by 2008.
Then, Governor Haruhiko Kuroda arrived in 2013 to supersize QE efforts.
The risk the US might follow Japan’s trajectory explains, in part, why Asia isn’t panicking just yet.
For one thing, the forces of globalization might reassert themselves to cap US inflation trends over time. For another, political divisions in Washington and worries about fragile markets from New York to Shanghai leave Powell limited latitude to hit the brakes.
As strategist Chetan Seth at Nomura Holdings puts it: “If you see a negative market reaction because investors are looking at the 2013 template and start selling stocks, we think that reaction should be short-lived.”
The thing about slashing rates to zero and beyond – as Japan demonstrates – is that central banks tend to get stuck.
There’s also the risk Japan might feel compelled to alter policies should US inflation accelerate, and spread. Makoto Sakurai, a former BOJ policymaker close to Kuroda, says the central bank must consider ways to trim its ginormous holdings of stocks via exchange-traded funds, perhaps by selling them to households.
“The BOJ needs to consider (how to exit) at some point,” he says.
The China angle here certainly adds a wrinkle. In the 12 years since the 2008-2009 global financial crisis, China became the second-largest economy and biggest trading nation on earth. That fast-increasing role dovetails with China’s status as the first major economy to recover from Covid-19.
China’s revival already has been lively enough to pull South Korea into the plus column. It’s added a hint of life to Japan’s 2021. In May, South Korean exports to China surged 22.7% year-on-year, contributing to the biggest overall monthly increase since 1988. Japan’s shipments to China jumped 23.6% on-year during the same month.
President Xi Jinping’s tolerance of a stronger exchange rate – the yuan is up 9% over the last year – is increasing China’s purchasing power around the region. That is helping morph Xi’s economy into a regional growth engine rivaling the US.
At the same time, China’s economic system is doing a better job of keeping surging factory-gate inflation from funneling into retail prices. For now, at least. Not exporting inflation the way Japan shares its deflation could win China big soft power points. So would playing the economic shock-absorber role the US typically does.
Even so, a US inflation battle leading to recession is the last thing the global economy needs heading into 2022.
For all the excitement over China opening its capital markets and internationalizing the yuan, there are valid reasons to worry about policy mistakes in what’s still the biggest economy. All Asia can do is hope Powell and his team land this airplane as safely as possible – and avoid a crash.