Federal Reserve Chairman Jerome Powell speaks during a press conference at headquarters in Washington, DC on May 5. ⓒEPA
At the dawn of May 5 (Korean time), the US central bank, the Federal Reserve, raised the policy rate range by 0.5 percentage points (0.25 to 0.50% → 0.75 to 1.00%). The central bank’s usual interest rate adjustment range is 0.25 percentage points, but it has been raised by 0.5 percentage points at a time, so it is a so-called ‘big step’. Although the rate hike was aggressive, US stock prices rose sharply, and the value of the dollar actually declined. Despite the Fed’s shock, the financial markets were not shaken.
If we understand the interest rate decision mechanism, it can be evaluated that the market’s reaction to the policy rate hike was quite reasonable. The policy rate is set by the central bank. Although the policy rate is very important, the policy rate is not ‘directly’ applied to the economic activities of ordinary people. Just like we don’t have to do business with the Bank of Korea in our lives. The market interest rate used in economic activities is determined according to the creditworthiness of economic agents and the prospects for future growth and inflation.
Nevertheless, market participants always pay attention to the decisions of the central bank. This is because central banks have almost exclusive powers to increase or decrease the liquidity (money) circulating in the economy. When the central bank increases liquidity, interest rates, the value of money, fall, and when liquidity decreases, interest rates often rise.
The central bank’s policy rate has a large effect on short-term interest rates with short maturities, and has relatively little effect on long-term interest rates with long maturities. It is natural. The interest rate that the financial market places importance on is the interest rate on long-term bonds with maturities of about 10 years, which central bankers cannot take responsibility for. The term of office of the chairman of the US Federal Reserve or the governor of the Bank of Korea is only four years. Interest rates with long maturities are determined by adding the collective intelligence of the market to the central bank’s policy rate.
In 2018, the Fed also tightened policy by raising policy rates to combat inflation. By the fall of 2018, the Fed’s policy rate was 2.25%, and the 10-year US Treasury yield was around 3.0%. Although the 10-year US Treasury yield has recently reached the 3% range, the Fed’s policy rate is still only 1.0% despite the big step. The gap between the policy rate and the market rate is much larger than in 2018. This should be interpreted as the Fed’s ‘practical instrument (失期)’. The market interest rate has already gone uphill quickly reflecting concerns about inflation, but the Fed is now making noises saying it is a ‘big step’ and a ‘giant step (0.75 percentage point increase)’.
The reason the financial market was not shaken despite the aggressive rate hike is because the market interest rate, which is practically important, has already risen, and the Fed’s breakthrough, paved with a big step, was in fact merely a step to post-mortem the path the market has already taken. am. Until last fall, the Fed maintained that inflation was only a temporary phenomenon. As a result, the Fed was wrong. In most cases, the central bank is leading the market, but this time the central bank is thoroughly guided by the market.
The surge in oil prices, a factor in inflation, was caused by geopolitical unrest after the Ukraine war. ⓒAFP PHOTO
For now, even if the Fed aggressively raises the policy rate, the rise in market interest rates will not be large. This is because the Fed is now hastily reflecting concerns about inflation in its policy rate, but market interest rates have already soared through this process. Uncertainties related to the Fed’s monetary policy are likely to increase as interest rates are set in late 2022 or early 2023.
The central bank raises policy rates to curb inflation, and in this tightening cycle, it is highly likely that inflation will not be caught even if interest rates are raised moderately. The central bank’s monetary policy only affects economic demand. The essence of austerity policy is to weaken inflationary pressure from excessive demand through interest rate hikes. However, the recent inflation is the result of a combination of demand factors such as the booming US economy and supply factors stemming from the COVID-19 pandemic and geopolitical tensions. Inflation in the US is skyrocketing, and the main reasons for the sharp rise in inflation over the past year were the surge in oil prices and used car prices. The surge in oil prices is largely attributable to the geopolitical unrest created after the Ukraine war, and the used car price uncertainty is due to disruptions in the supply of semiconductors for new car production due to the spread of Corona. A central bank rate hike won’t end the war, nor will it stop the spread of the disease.
The possibility of a recession…
While US monetary policy over the next several months is only a process to close the gap with the market it has rushed to, serious concerns will arise once these adjustments are finalized. The question is how to deal with inflation in the presence of inflationary pressures on the supply side that the central bank cannot control. Inflation itself, whatever its cause, is very detrimental to the economy. If the Fed chooses to catch inflation at all costs, a serious recession will follow. There is no way to tackle price instability on the supply side without a serious pullback in demand.
A more probable scenario is if a recession occurs regardless of the Fed’s active intentions. No central bank would want to raise interest rates, leading to a serious recession and asset market collapse. The problem is that the causes of inflation cannot be accurately decomposed into supply and demand factors.
The ideal interest rate level that will not stimulate the economy and cause inflation or recession is called the ‘neutral interest rate’. The central bank pursues a neutral interest rate, but it is a very value-oriented and conceptual value rather than objectively existing. The central bank thought it was a neutral rate, but the level could be an interest rate that causes overheating or, conversely, an interest rate that causes a serious recession. This can only be determined ex post facto. Under the current circumstances, it seems that the possibility of raising interest rates to catch inflation rather than under-reacting to inflation and hitting the threshold for negative effects on the economy as a whole is relatively high. The central bank is likely to face a difficult choice at the end of this year or early next year, when the gap between the policy rate to be raised diligently and the market rate that has already run has narrowed.