The much-anticipated US recession, if and when it does arrive, will undoubtedly extract a price from economies in the Asia-Pacific. That doesn’t mean the US Federal Reserve’s efforts at mitigating the slowdown are going to be any less expensive for the region.
The source of that economic cost is inflation—both the part that’s already realized because of sky-high commodity prices and the part that’s expected from the current round of US monetary expansion.
Actually, even the elevated prices of minerals, metals and food may be less a result of explosive world demand, led by China and India (which is nowadays the standard explanation proffered by many economists) and have more to do with cheap money, as Harvard University professor Jeffrey Frankel has recently argued.
If Frankel’s hypothesis is correct, monetary policy options for the Asia-Pacific region are very limited.
No matter what they do, the inflation genie won’t go back into the bottle without a huge global deflationary shock, precisely the kind of US recession that the Fed is so intent on preventing.
With crude oil at about $106 (Rs4,293) a barrel, and wheat futures almost two-and-a-half times as expensive as at the same time last year, fuel and food prices are a big worry for policymakers.
Declining US interest rates and a weakening dollar are compounding the challenge.
The situation is peculiarly tricky for central banks that don’t set interest rates independently, opting instead to import monetary conditions prevalent in the US.
Negative real rates
All of these monetary authorities are now being forced to live with real—or inflation-adjusted—interest rates that are already negative and continuing to fall, stoking potentially dangerous speculative fervour in property markets and feeding into expectations of higher wages.
Saudi Arabia, the United Arab Emirates and Bahrain, which peg their currencies to the US dollar, were forced to cut their benchmark rates by 0.75 percentage point on Wednesday, following the reduction by the same amount in the Fed’s target for interbank rates.
The Hong Kong Monetary Authority—which also maintains the value of the local currency against the US dollar —had to make a similar change on Wednesday to its base rate.
“With higher inflation and with our economy continuing to perform strongly, we would have liked to see positive rather than negative real interest rates,” Joseph Yam, the Hong Kong Monetary Authority chief, said last month. Inflation in the Chinese territory is at a nine-year high.
Countries that have more flexible exchange rates—and, therefore, greater freedom in setting the price of local money—are not exactly on top of inflation, either.
The Reserve Bank of India is under pressure to cut interest rates. But with inflation having accelerated to a nine-month high, and the fiscal taps wide open, the elbow room for monetary easing is simply not there.
Or, take Australia, the world’s biggest exporter of coal, iron ore and wool. Even with interest rates that are at their highest in 12 years, Australian inflation is still the fastest in 16 years.
Buoyed by commodities, Australia’s terms of trade —the average price of its exports divided by the cost of its imports—have surged 41% in the past five years.
Such good fortune, not seen since the Korean War “boom” of the 1950s, shows “a very large change in relative prices in the world economy,” governor of the Reserve Bank of Australia Glenn Stevens said at a seminar in Canberra this month. This change is “very expansionary” for Australia, he said.
But why are commodity prices rallying even with all the concerns about the US slipping into recession? Harvard’s Frankel says the culprit is the low real cost of borrowing. That makes it cheaper to carry inventories.
The Fed may have developed inflation amnesia; the bond market has not. The yield on five-year treasury inflation-protected securities is signalling a steady rise in expectations of quicker longer-term price gains.
Then there’s China, where the current annual inflation rate of 8.7% is double the one-year yuan deposit rate.
None of this gives any comfort to Asian central banks.
With the US “at risk of a recession, Hong Kong will be affected sooner or later,” Yam wrote last month. “Hopefully, the prospect of some slowing in our economic growth rate will have a damping effect on domestic inflation.”
The operative word here is, “hopefully”.
Policymakers in the Asia-Pacific do want to see the US financial system quickly restored to normalcy because the pain of credit market disruption is spreading to their own banking industries. But if that’s to be achieved with nominal US interest rates at, say, 1%, then they would rather suffer the consequences of a US recession that also slows the economy of China, causing commodity prices to moderate.
What, after all, is the use of a cure that turns out to be worse than the disease?
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