Asian central banks are in no hurry to follow the United States in tightening monetary policy, with investors apparently confident the region can ride out reflation.
On Wednesday, the U.S. central bank’s Federal Open Market Committee (FOMC) increased official interest rates by the second time in three months, the first tightening under U.S. President Donald Trump, but a move widely expected by analysts.
Responding to improved economic activity, the FOMC raised its target range for its federal funds rate by 0.75 percentage point to 1 percent, a stance it described as “accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.”
The FOMC said further hikes would be based on its assessment of “realized and expected economic conditions” related to its inflation and employment objectives, with only gradual increases likely.
Fed chair Janet Yellen said the FOMC’s median projection for the benchmark rate was 1.4 percent at the end of 2017, 2.1 percent by year-end 2018, and 3 percent the following year, “essentially unchanged” from its December projections.
The world’s biggest economy is seen expanding by 2.1 percent this year and next, with the governor suggesting it was “too early to know” the effects of Trump administration policies.
China Hikes, Japan Unchanged
U.S. and Asian markets responded positively to the Fed’s continued caution on rate hikes, with stock markets gaining and bond yields dropping. Across the Asia-Pacific, the Hong Kong, Shanghai, Sydney, and Tokyo bourses all rallied, although central bank chiefs in China, Japan, and Indonesia showed differing responses.
The People’s Bank of China (PBoC) responded to the Fed’s action by raising money market rates by 10 basis points (0.1 percentage point), with its seven-day reverse repo rate increasing to 2.45 percent and the one-year medium-term lending facility rate climbing to 3.2 percent. However, it said the move did not signal a change in policy, with its benchmark deposit and lending rates staying unchanged.
ANZ Research said China’s move could be interpreted as “a precautionary move for exchange rate stabilization.”
“Since China cannot forever rely on administrative tools to manage exchange rate expectations, the central bank’s action today signals that China is wary of capital outflow pressure and is beginning to consider the interest rate spread between the [U.S. dollar] and the [Chinese yuan] in its monetary policy framework,” the Australian bank’s economists said Thursday.
“But the main reason is that the PBoC is engineering a monetary policy transmission mechanism in the money market and the central bank needs to catch up with the market anyway.”
ANZ Research said the PBoC’s tendency to partially follow the Fed could result in another 20 percentage point tightening by the end of 2017, “assuming that the Fed will hike by another 50 basis points for the rest of the year.”
However, higher money market rates in China could pressure non-bank financial institutions and smaller banks, along with an increasing crackdown on the shadow banking sector, ANZ said.
Julian Evans-Pritchard, China economist at Capital Economics, also predicted further tightening by China’s central bank, forecasting the seven-day reverse repo rate would end the year at 3 percent.
Yet while China was tightening, Japan’s central bank left policy unchanged Thursday as it continued its fight against deflation. The Bank of Japan (BoJ) said it would continue applying a negative interest rate of minus 0.1 percent to accounts held by financial institutions at the bank, while maintaining 10-year Japanese government bond yields at zero percent, keeping the current pace of purchases at about 80 trillion yen ($923 billion).
“Japan’s inflation is maintaining its momentum toward [the bank’s target of] 2 percent, but it is lacking strength,” BoJ governor Haruhiko Kuroda explained. “We deemed it appropriate to continue with our powerful monetary easing program to reach this target at the earliest possible time.”
While analysts have pointed to an end to the BoJ’s ultra-easy money policy in 2017, Kuroda gave little indication he was in a hurry to hike rates. Japan’s Nikkei newspaper pointed to lackluster wages growth as the main culprit, despite a strengthening labor market that has seen the job-to-applicant ratio hit a 25-year high.
While annual wage negotiations between Japanese labor and management have resulted in a fourth straight year of base pay hikes, a Nikkei survey found most were offering either smaller or the same increases as in 2016.
“The BoJ has said repeatedly that we intend to create a virtuous cycle where wage and corporate earnings rise in conjunction with the inflation rate. That companies are planning a fourth consecutive year of wage raises supports this,” Kuroda said. “I hope these efforts continue on both labor and management levels.”
However, with the yen weakening and oil prices increasing, inflation is starting to climb. In January, consumer prices excluding fresh food showed their first year-on-year rise in 13 months, increasing by 0.1 percent, with predictions the index will exceed 1 percent by year-end.
According to ESP Forecast, over 40 percent of Japanese private-sector economists expect the BoJ’s next policy move will be to tighten. With Kuroda’s five-year term ending in April 2018, the central bank governor likely will pull out all stops to achieve his targets, officials suggest.
Meanwhile in Indonesia, the central bank kept its seven-day reverse repo rate steady at 4.75 percent Thursday, citing the need to maintain stability in Southeast Asia’s largest economy. All 20 analysts polled by Reuters had forecast no policy change from Bank Indonesia (BI).
“The decision is in line with BI’s efforts to maintain macroeconomic and financial stability amid rising global uncertainty,” the central bank said in a statement.
BI has kept its policy settings steady for five consecutive meetings after having cut rates six times in 2016. With annual inflation of 3.8 percent inside its target band, and amid softer economic growth in the fourth quarter, the central bank is seen keeping rates steady to ward off any inflation spike from higher food and electricity prices.
However, Asia’s central bankers will also be nervously watching the currency effects of higher U.S. interest rates and a stronger dollar. South Korea’s central bank reportedly may be among those no longer capable of easing rates, even if domestic conditions soften.
“Its policy rates are now barely above that of the Fed and if that yield premium narrows too much, a huge amount of foreign money in its bond market could flee,” Reuters said.
“Monetary tightening is probably an inevitable trend in the U.S., China, Europe, and even Japan. Europe and Japan have already pushed quantitative easing to the extreme and there is not much room for further easing,” said Margaret Yang Yan, market analyst at CMC Markets Singapore. “So in the future, money will become more and more expensive to borrow.”
Yet not all economists believe Asia will follow the Fed’s lead, given the region’s differing circumstances.
“In a sharp departure from 2004-06, we believe that most Asian central banks are unlikely to respond to the current tightening cycle in the U.S. Growth conditions in much of the region remain lackluster, necessitating accommodative monetary conditions,” ANZ economist Weiwen Ng said in a March 17 report.
Ng said China, India, Malaysia, and South Korea were the most exposed to the Fed’s tightening, with their “reserve adequacy” having deteriorated since the last Fed tightening cycle in 2004. This could force interest rates higher in these nations to protect their currencies, in the face of potential capital flight.
Similarly, a weakening of the growth outlook for China, the world’s second-biggest economy, would hit its neighbors with the most exposure to China, including Singapore, South Korea, Taiwan, and Thailand.
Nevertheless, bond investors have shrugged off the risks thus far, with offshore investors pouring in more than $13 billion into the debt markets of India, Indonesia, South Korea, and Thailand in 2017, according to Bloomberg News.
“Emerging Asia scores relatively well on both macro as well as political stability and is likely to remain an attractive region to invest in for the foreseeable future,” said PineBridge’s Anders Faergemann. “The short-term risk is mainly associated with external factors as the markets fear the Fed is behind the curve.”
Should the Fed change its stance and pursue a faster pace of tightening, Asian investors could feel the pain with currencies, stocks, and dollar-denominated debt all coming under pressure. But for now, Yellen’s softly, softly approach and signs of an improved global outlook have kept Asian markets moving higher, even with the prospect of more expensive debt.
