Takahide Kiuchi's View - Insight into World Economic Trends :
Searching for a Turning Point in US Monetary Tightening Policies, Which Hold the Key to the Yen’s Depreciation and the Global Economy
Jun. 10, 2022
Since March, the currency market has suddenly begun showing more pronounced weak yen/strong dollar tendencies, and we’re now seeing the yen at its lowest levels in 20 years. What’s driving the yen’s depreciation more than anything else now are speculations about rapid monetary tightening in the US, as well as the rise in long-term US interest rates as a reflection of them. The question of at what point down the road the pace of US monetary tightening policies will slow down is one that I think will significantly influence not only the yen’s depreciation, but also global economic trends going forward.
The pace of monetary tightening in the US picks up
In order to cope with soaring prices, the FRB (Federal Reserve Board), which is the central bank of the US, decided at the FOMC (Federal Open Market Committee) meeting on monetary policy held in March to embark on a course of raising interest rates—i.e., policy interest rate hikes—for the first time since 2018. While the scope of this rate hike was only 0.25% at that time, at the following FOMC meeting in May, the FRB raised rates by another 0.5%, the largest such hike since 2000.
It would appear that there were growing concerns within the FRB that a conventional rate hike of 0.25% wouldn’t be enough of a policy response to counteract the highest levels of inflation seen in 40 years, and that it would therefore fail to get a handle on the rate of inflation. This acceleration in rate hikes has reinforced the sense in the currency market of a widening interest rate gap between Japan and the US, and it’s prompted the yen to depreciate even further.
The FRB has also advised the market that following the May meeting, it may even raise interest rates by 0.5% at both the June and July FOMC meetings, which would make three consecutive meetings involving such rate hikes, and that view has become a solid consensus—or the average view—in the financial market.
While there’s no firm market opinion yet regarding FOMC forecasts from that point onward, the market already anticipates a 0.25% rate hike to be announced at the September FOMC meeting, which will be the next one after July. However, if the US economy stays strong and inflation remains high, it might reinforce expectations in the financial market going forward that another 0.5% rate hike will be implemented at the September FOMC meeting. Or there’s even a lingering chance that the market may come to speculate that an even larger rate hike of 0.75% will be implemented at the FOMC meetings in between now and September.
Given these points, there’s still room for speculation to grow in the financial market that the FRB’s monetary tightening could come more quickly than anticipated. That would likely cause US long-term interest rates to increase even more, and even lead the weak yen/strong dollar tendencies to intensify further. We may need to be resolved to see the yen depreciate to the level of 140 yen to the US dollar.
The spotlight is on the September FOMC meeting
However, this situation in which monetary tightening by the FRB outpaces market expectations won’t continue indefinitely. Meanwhile, the view has started to emerge in the financial market that the September FOMC meeting could potentially be a turning point for US monetary policy.
The FOMC members responsible for monetary policy within the FRB are currently all in agreement about prioritizing the need to raise policy interest rates as rapidly as possible to a neutral level with respect to economic activity. This approach has to do with the desire to quickly eliminate easy monetary conditions and thereby prevent their policy measures from lagging behind the current steep price increases. It seems like they’re raising interest rates and keeping their eyes shut until this neutral level is reached, as it were.
This sort of policy stance is also evident in the remarks made at the end of May by James Bullard, the President of the Federal Reserve Bank of St. Louis, who is a member of the FOMC. Mr. Bullard stated that no matter what happens to the economy, it’s crucial to get policy interest rates to reach 2%, which he considers to be a neutral interest rate. He’s also expressed the desire to raise interest rates as fast as possible, to curb inflation and avoid having to contend with long-term problems that could last a decade.
That said, the view that the September FOMC meeting could serve as a turning point for monetary tightening policies has also been voiced by FOMC members themselves, and this is something worth noting.
Federal Reserve Bank of Cleveland President Loretta Mester observed in a speech she gave at the beginning of June that “If by the September FOMC meeting, the monthly readings on inflation provide compelling evidence that inflation is moving down, then the pace of rate increases could slow.”
And in late May, President Raphael Bostic of the Federal Reserve Bank of Atlanta also commented that “I have got a baseline view where, for me, I think a pause in September might make sense.”
Policy interest rates in the low 2% range an important milestone
Why would the September FOMC meeting constitute an important turning point that could see the pace of monetary tightening slow down, or perhaps even bring monetary tightening to a halt? Because it marks the time when policy interest rates will come close to reaching a neutral level, that’s why.
It’s a generally shared view among FOMC members that somewhere in the low 2% range would be a neutral policy interest rate level relative to economic activity. What’s more, the forecast for the September FOMC meeting is for policy interest rates to approach a neutral level in the range of 2.0% to 2.25%, or alternatively between 2.25 and 2.5%.
If that happens, the FRB will likely take a moment to reassess economic, price-related, and financial market trends, and be inclined to carefully contemplate its future policies. Furthermore, if the FRB were to consider changing its stance, for instance by slackening the pace of its monetary tightening, then it would probably communicate as much to the financial market. Consequently, long-term interest rates in the US would cease their ascent, and the ongoing depreciation of the yen might even come to a halt as well.
There’s one other crucial significance to having policy interest rates reach a level between 2.25% and 2.5%. This is the same level as that of the peak that policy interest rates reached back in 2018, during the last monetary tightening phase.
Now, major events including the COVID-19 pandemic and the invasion of Ukraine have arisen in the time since then, and the inflation rate is much higher than it was at that time. Nevertheless, assuming that the current high rate of inflation is temporary and economic structures don’t fundamentally change, we can expect that if policy interest rates do reach this level, they’ll start to put the brakes on economic activity, just as they did the last time around.
In this sense as well, policy interest rates in the range of 2.25% to 2.5% would constitute a milestone, prompting the FRB to suggest a change in its stance at the September FOMC meeting, and potentially that could have a major effect on the financial market.
Can the US economy avoid a hard landing?
Confronted with the highest inflation rates in 40 years, the FRB has tried to handle things with arguably the most rapid monetary tightening in 40 years. During the previous round of interest rate hikes, the total extent of the hikes in the one-year period from their inception was only 0.5%, but this time we could see a total range that’s six times that or more.
With the growth potential of the US economy seeming to be significantly lower than it was 40 years ago, if monetary tightening is implemented this rapidly, it could eventually cause the US economy to deteriorate significantly, and quite possibly even bring about a recession.
Currently, the view is widely supported that the US economy in 2023 will be in what’s called a “growth recession”, where rapid monetary tightening will cause the economy to slow down but not quite stall.
However, if the pace of monetary tightening remains this rapid from the fall onward, and policy interest rates are raised in the short term to a level that greatly surpasses the peak seen in the previous round of monetary tightening, then there will be a higher risk of this tightening of monetary policy going too far, causing the US economy to deteriorate beyond any expectations, and leading to a so-called “overkill” situation. In that event, it’s possible that the US economy in 2023 wouldn’t experience a soft landing that stops at a growth recession, but would make a hard landing instead.
From this perspective, the determination to be made by the FRB this fall with regard to monetary tightening could potentially mark an important milestone, one that significantly affects not just the depreciation trend of the yen, but also what lies ahead for the US economy and that of the entire world.
And here’s another thing to note: if excessive monetary tightening by the FRB does lead the US economy to make a hard landing, then as expectations of monetary easing start to emerge and US long-term interest rates begin to plummet, we might even see the currency market swiftly roll back to a strong yen/weak dollar scenario.