Takahide Kiuchi's View - Insight into World Economic Trends: The Normalization of Monetary Policy Around the World and Emerging Financial Risks
Oct. 08, 2021
Among the world’s central banks, there has been a growing momentum to gradually eliminate the substantial monetary easing measures that were put in place in response to the Covid-19 pandemic. On October 6, the Reserve Bank of New Zealand (the country’s central bank) raised interest rates for the first time in seven years (a policy interest rate hike). South Korea’s central bank had decided to do the same in August, with the central bank of Norway following suit in September. The reasons underlying these moves included the fact that their economies were following an upward trajectory, as well as pickups in inflation and soaring housing prices. We need to pay attention to the effect these developments will have on financial markets in the future.
The focus of US monetary policy is shifting from tapering to rate hikes
It would seem quite likely that the US Federal Reserve Board (FRB) will begin a phased reduction, or “tapering”, of its asset purchase program this November. The European Central Bank (ECB) could also begin to implement such tapering in December. In particular, normalization measures taken by the FRB would be a major event catching the attention of the world’s financial markets.
The last time that normalization measures were enacted, in May 2013, the FRB brought about a “taper tantrum” wherein its suggestion that tapering would be implemented shook the financial markets. The return of capital to the US sent emerging markets into chaos, with the FRB drawing strong criticism for the move. With the FRB poised to embark on tapering once again, there is no sign at present of a similar situation occurring. That might be because the asset purchase program is no longer considered to be as important a policy as it used to be.
Compared to interest policies that directly stimulate short-term policy interest rates, the policy effects had by adjustments to the bank’s asset purchases through changes to long-term interest rates are uncertain.
The impact to global financial markets will likely be more significant this time not from the tapering itself, but rather from the interest rate hikes that will follow. The FRB has regarded the pickup in inflation as a temporary phenomenon and has not shown very much alarm at the currently soaring housing prices, for example. Given this, it would appear to be a little late in hiking interest rates compared to other central banks.
At the September meeting of the Federal Open Market Committee (FOMC), nine of the 18 members—fully half—expected that rates would be raised at least once in 2022, and foresaw a total of four rate hikes or more by the end of 2023. However, the actual timing at which these rate hikes will commence might well be later than the forecasts by the FOMC members, which were based on optimistic economic prospects. A deteriorating real estate market and power shortages have increasingly put the brakes on China’s economy, and the impact from this will likely extend to the US economy as well. In addition, rising prices (especially for energy) and the dissipating effects of economic measures taken in response to Covid-19 could lead the US growth rate in 2022 to be weaker than expected.
The last time that the FRB raised the Federal Funds Rate was in December 2015, which came 24 months after the start of tapering, and 14 months after tapering had been brought to an end. If we were to simply apply this model to the current case, assuming that tapering commences in November of this year, rate increases would begin in November 2023, precisely two years later.
With these points in mind, we may perhaps expect that the world’s financial markets in the period from 2021 to 2022 will not yet be greatly disturbed by the FRB’s anticipated rate hikes, and will remain relatively stable.
Distortions of financial markets inflated by the Covid-19 response, and “rate hike tantrums”
The problems will emerge starting in 2023, when the markers are expected to first show real concerns about the FRB’s upcoming rate hikes. In response to the turmoil in the financial markets in March 2020, or the so-called “Corona Shock”, the FRB took very rapid measures including lowering policy interest rates abruptly to near-zero levels. This most certainly helped bring a relatively quick conclusion to the market disruptions.
However, this response was ultimately an excessive one, and seemingly encouraged the financial markets to overheat. In particular, it greatly pushed up even further the prices of securitized products such as CLOs (a type of mortgage-backed security) and CMBSs (commercial mortgage-backed securities), which were already relatively pricey before the Corona Shock, as well as the prices of high-yield bonds, BBB-rated corporate bonds (the lowest investment-grade rating), and other high-risk assets.
It seems quite likely that as the FRB effects these rate hikes going forward, those prices will be adjusted. If those adjustments happen rapidly, then hedge funds, mutual funds, money market funds (MMFs), and other non-bank (“shadow bank”) entities which own them in large quantities will incur huge losses. These institutions will then be forced to dump all sorts of financial assets in order to meet their clients’ withdrawal demands, which could trigger massive disruptions in the markets overall.
The one thing that the markets need to prepare for now is not a taper tantrum, but rather the “rate hike tantrum” that will ensue afterward.
Three scenarios for the FRB’s rate hikes
There are, broadly speaking, three conceivable scenarios to consider regarding the relationship between the FRB’s rate hikes and the financial markets. In the first scenario, the financial markets would undergo major adjustments as the FRB carries out its rate hikes. In the second, the FRB would hedge on implementing steady rate hikes to prevent turmoil from gripping the financial markets, but that hesitancy would only amplify market distortions, leading the markets to autonomously enter a major adjustment phase. In the third, the FRB would proceed steadily with raising rates while accepting a certain degree of market volatility, allowing market adjustments to unfold over time and permitting the markets to “de-gas”, as it were, thereby avoiding any severe financial market turbulence.
The third scenario would be the most desirable when it comes to the medium- and long-term stability of the financial markets, but I believe the chances of that happening are probably no greater than 50%.
Will the issuance of a “Digital Renminbi” create turbulence for global financial markets from 2023 onward?
Furthermore, it is possible that while the FRB is pushing ahead with its rate hikes, this process could encourage the outflow of capital from developing nations. We could potentially even see a type of chaos even worse than that of the old taper tantrums. This is because extra-economic factors, namely declining US economic influence and the Covid-19 pandemic, will only prolong the economic disparities between the US and developing nations, and that will likely have a major impact on international capital flows through disparities in these countries’ monetary policy stances.
Further, there is something that we cannot overlook when forecasting what lies ahead for the world’s financial markets in 2023 and beyond - the issuance of a “digital renminbi”, the Chinese central bank digital currency (CBDC) expected to be available in 2022. China presumably wants to use this as a catalyst for internationalizing the renminbi, with the aim of challenging US currency and monetary hegemony. Once this currency is issued, the priority will likely be spreading it domestically in China, but from 2023 onward its use abroad is expected to gradually expand.
Let us imagine a scenario based on the countries taking part in China’s “Belt and Road” infrastructure investment initiative, involving a future in which a Chinese economic zone is formed, with the renminbi playing a role as the de-facto reserve currency. In that case, the proportion of the world’s foreign exchange market taken up by the renminbi would go from 2.2% (September 2019) to around 18%, a rise of nearly 16 percentage points. If use of the US dollar were to fall proportionately, the dollar’s composition ratio would similarly drop from 44.2% to around 28%. The gap in composition ratios between the dollar and the renminbi would shrink down to just around 10%, meaning the dollar’s influence would decline considerably.
From 2023 onward, we can expect to see mounting concerns over the dollar’s loss in status, brought on by the FRB’s rate hikes and the issuance of the digital renminbi. Consequently, we should likely steel ourselves now against a growing risk that developments in the US could set off a tumultuous time for global financial markets.