Asia: Fear not the Fed, but do the homework

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Janet Yellen

Some Asian economic officials worried at the last G-20 meeting of finance ministers and central bank governors (Cairns, Australia, September 20-21, 2014) that a widely expected monetary tightening in the United States would force them to follow suit and damage their own growth dynamics.

I am assuming that this was an earnest policy concern rather than the usual attempt to blame policy mistakes on the proverbial external shocks.

With that important clarification out of the way, I would like to calm these Asian fears with two arguments.

First, the Federal Reserve is nowhere close to any policy change that would force Asian countries into growth-stifling interest rate hikes. And whenever such changes begin to take place, they are likely to be gradual and largely within the range of policy-neutral real interest rates.

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Second, most of Asia's largest economies (China, Japan, India, South Korea and Indonesia) could cope with the normalization process of U.S. monetary policies with some adjustments to their macroeconomic conditions.

The Fed's party is still on

Provisional data for the first half of this month indicate that the Fed's balance sheet continues to grow after an $85.9 billion expansion in the course of August. That keeps the Fed's high-powered money advancing at an annual rate of 20 percent.

With these liquidity developments, it's easy to conclude that the Fed is not even thinking of moving the federal funds rate toward the upper range of its 0-0.25 percent target. Indeed, the effective fed funds rate was 0.08 percent at the close of trading last Friday -- exactly where it was a year ago.

The question is: Are the bond markets nervous about this because, normally, bond traders are the first to pass a vote of no confidence on Fed's policies?

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The answer is clear: The yield on the benchmark ten-year Treasury bond fell by nearly 10 basis points last week, despite a significant upward revision of America's economic growth in the second quarter of this year. Taking a longer view, that key Treasury's debt instrument was yielding last Friday exactly 50 basis points less than at the beginning of 2014.

You may call this the market history. That would be correct. But the Fed's present policy posture and, more importantly, the current long-term bond yields give us the glimpse into the U.S. economic outlook anticipated by the Fed and by the collective wisdom of bond market investors.

There is nothing here that Asia should worry about. On the contrary, the prospect of America's stronger and sustained growth and the rising dollar are good for Asian exports.

Thank the Fed and do the homework

Asia, therefore, has to look into the sustainability of its own macroeconomic balances.

And here is as close as you can come to the case of economic perfection in Asia and beyond: South Korea has stable prices, balanced public sector accounts, neutral monetary policy, stable currency, trade surpluses and an economy on course for a 3.5-4.0 growth rate for this year as a whole.

Apart from any unlikely trouble in the neighborhood, the only thing this economy can fear is a weak U.S. domestic demand. That could hit Korean exports to America – a total of $26.4 billion in the first half of this year and a 10 percent increase from the same period of 2014. Seoul, therefore, can only cheer the Fed's growth-supporting policies and a strong dollar.

South Korea can be an example to those in Asia who apparently believe that the Fed's widely expected policy adjustment will lead to their rising interest rates and declining economic growth.

These countries do exist. They are running budget and trade deficits, along with high and/or suppressed inflation rates. If they let things go, they could face increasingly expensive financing conditions in global markets; they might also have to raise interest rates to attract foreign portfolio capital flows.

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As always, inflation, being a corollary to internal and external deficits, raises the specter of broader issues.

Some Asian countries experiencing high or suppressed inflation may find the prospect (however distant) of rising interest rates in the United States a convenient reason for rate hikes that currently seem politically problematic without an external pretext. But these countries would have no option of letting their currencies depreciate in response to the rising dollar -- a significant handicap to export-driven Asian economies.

That problem might be more widespread and imminent than most people seem to think. As a frequent visitor to various East Asian countries, I have repeatedly observed that apparently well-behaved inflation rates in many places don't square with my plunging real purchasing power.

In fact, my casual observation seems to coincide with those of some U.S. economic analysts who published research last week arguing that a number of emerging markets (including Asia) will soon see substantial interest rate increases in response to their rising inflation pressures.

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Investment thoughts

A sad spectacle of a Europe tearing itself apart has benefited Asia over and above its intrinsic investment allure. That will continue. Europe's homegrown terrorist threats, intractable security problems and seemingly unbridgeable disagreements about economic policies will continue to depress euro-denominated asset markets.

Asia, by contrast, is coming together. The fallout from serious territorial issues has been wisely managed. The next APEC meeting in Beijing (Asia-Pacific Economic Cooperation, November 4-7, 2014) could well be an opportunity for thawing relations among China, Japan and South Korea. Even the North Koreans are chiming in with friendly noises about peace and confederation with their estranged cousins to the south.

Unlike in Europe, Asian atmospherics are improving. The China-Japan multichannel diplomacy is in full swing. Japan – whose business with China and South Korea has been declining sharply since the beginning of this year -- seems firmly determined to get its Chinese and Korean neighbors into unlocking the prodigious economic potential of a peaceful, prosperous and industrially advanced Northeast Asia.

These three countries don't seem overly concerned about the possibility of rising interest rates in the U.S. Other Asian economies may have to be more careful about their budget deficits, trade gaps and actual inflation pressures.

Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.