Rising oil prices and US interest rates are a volatile combination for emerging markets
Neal Kimberley says the Federal Reserve chairman has downplayed the impact of US monetary policy on the global economy, but market analysts beg to differ
“Asia remains vulnerable to a tightening in global financial conditions,” said the International Monetary Fund’s Changyong Rhee in Hong Kong on May 9. With rising oil prices and the US Federal Reserve still tightening policy, that statement is likely to be tested.
The fact that the Fed seems to think the global effect of its monetary policy tightening isn’t that great won’t help the situation.
Federal Reserve chairman Jerome Powell, speaking in Zurich on May 8, said that “the influence of US monetary policy on global financial conditions should not be overstated”, arguing that “monetary stimulus by the Fed and other advanced-economy central banks played a relatively limited role in the surge of capital flows” to emerging market economies in recent years.
Consequently, Powell said, “there is good reason to think that the normalisation of monetary policies in advanced economies should continue to prove manageable” for emerging markets.
Markets might take some convincing. As Rhee, the IMF’s director of the Asia and Pacific Department, said, “In the last few weeks, US 10-year sovereign yield started rising, the US dollar strengthened, and capital flows to emerging markets slowed down.”
Markets might legitimately decide that sequence of events is attributable to tighter US financial conditions, even if Powell would demur.
The findings of a Bank for International Settlements working paper, published on May 4, also seem somewhat at odds with the Fed chief’s viewpoint.
US monetary policy “spillovers are statistically and economically significant for both developed and emerging market economies, and have become relatively larger after the global financial crisis,” the paper concluded. Indeed, between October 2008 and December 2016, the spillover effect of US monetary policy on local emerging market long-term bond yields was significantly larger than the effect of domestic monetary policy.
But, of course, US monetary policy is only made by the Fed, and as it has convinced itself its actions don’t have material spillover effects, and because both market pricing and US domestic data point to further moves, the US central bank will keep tightening policy, through actual rate hikes and its programme of quantitative tightening.
“The market is pricing in two and one-third additional [Fed] rate hikes before year-end,” US bank BNYMellon wrote on Friday. “The June meeting is essentially showing full odds, while the September meeting is assigned a 75 per cent probability that we will see yet another hike then.”
Douglas Porter, chief economist at Canada’s BMO Capital Markets, argued on Friday that “with the US now sporting more job openings (6.5 million) than jobseekers, for the first time on record, don’t expect [US] wages to stay slow for long.” With US unemployment at just 3.9 per cent, its lowest level since 2000, the Fed might well share Porter’s opinion and react accordingly.
Of course, as the IMF’s Rhee said, even if Asia is vulnerable to a tightening of global financial conditions, exchange rate adjustment which occasions local currency weakness can take some of the strain, if domestic economic conditions, notably subdued inflation, don’t immediately require higher interest rates.
But in many cases that will just expose another vulnerability.
By definition, local currency depreciation means a higher price, in local currency terms, for US dollar-denominated imports, even if it makes local exports to the US more competitive.
That is particularly relevant for countries which rely on imported energy, when, as currently, the oil price is rising at the same time as US monetary policy conditions are tightening. A weaker local currency would buy even fewer barrels of crude as oil itself rises in price in US dollar terms. That would encourage a spike in imported inflation, requiring a monetary policy response.
Already, last week, the Philippines central bank raised rates by 25 basis points to 3.25 per cent amid an uptick in inflationary pressures over the past few months, an uptick that a fall in the value of the Philippine peso versus the US dollar during 2018 has, at least partly, encouraged.
“This is the first rate hike since September 2014, and is unlikely to be the last,” wrote Sophia Ng, an analyst at the Singapore branch of Japan’s MUFG bank, on Friday. As Ng noted, with the Philippines, a net oil importer, “higher oil prices would make oil imports more expensive and result in wider trade deficits”, weighing on the peso.
Tighter US monetary policy, a Fed that doesn’t think its actions have much of a spillover impact on others and a rising oil price – that feels like quite an ugly combination for Asian economies.
Neal Kimberley is a commentator on macroeconomics and financial markets