Seldom does the US Federal Reserve leave financial market expectations unconditioned in the run up to its policy setting deliberations. But it did do so prior to its November 16 meeting. Players were left divided whether the Fed would tighten its key benchmark interest rates or not. In the event, it did raise both the Federal Discount Rate (the rate at which the central bank lends to banks, if necessary) and the Federal Funds Rate target (FFR - the overnight interbank lending rate) by 25bps to 5 per cent and 5.5 per cent respectively. It also altered its policy bias from 'tightening' to `neutral'.Last week's rate-hike marks the third in the past five months. It takes back, in totality, the cuts triggered by the global financial crisis in the autumn of 1998. But the current tightening spree might not yet be over. Whatever be the reasons for the Fed's non-committal behaviour prior to its recent meeting, one thing is clear: the central bank continues to be faced with the challenge of grounding a high-flyingUS economy. Meeting the challenge will necessarily demand further monetary action in the spring of the new year. The ensuing slowdown in the US economy will force Asian countries to redouble their efforts to bolster other engines of growth internally. The bottomline is Asian interest rates are unlikely to rise in the first half of 2000.
New paradigm
To be sure, the US economy has had an exceptional ride in the nineties. In particular, the performance over the past three years has been extremely impressive. Even as the rest of the globe reeled under the onslaught of a severe crisis for the greater part of 1997-99, US GDP growth has averaged a hefty 4-per cent year-on-year with the tail end exhibiting remarkable strength. Inflation, meanwhile, has stayed benign around 2 per cent year-on-year. The continuing favourable output-price matrix, not surprisingly, has led several observers to conclude that a new paradigm is at work in the US economy and one which is obviating the need for any further ratehikes.
But in as much as the new paradigm theory has some merit `rising productivity has, indeed, been the cornerstone of non-inflationary growth' its nebulous outlook is unlikely to persuade the Fed into abandoning its traditional monetary framework. The crux of the matter in the US is today the continuous outstripping of supply by demand. That is threatening to aggravate already severe macroeconomic imbalances in the economy: a dwindling pool of available labour resources as is evident from the record low 4 per cent unemployment, and a heavy dependence on foreign capital as reflected by the widening C/A deficit to a 12-year high of 3.7 per cent of GDP.
While the former imbalance does not bode well for inflation, the latter risks triggering a mini BoP blowout, especially if the ongoing economic recovery in Japan and Euroland (together accounting for over two-fifth of the global output) is sustained. Untackled preemptively, these imbalances will come in the way of a soft US landing and might force theFed to eventually jam the brakes hard.
Fed to remain on the alert
It is a prospect the Fed will clearly not relish. It will be mindful of placing all its eggs on the productivity factor. That is why, despite the absence of any significant inflation on the horizon, it will continue to steadily hike the Federal Funds Rate to an estimated 6.25 per cent by the middle of 2000. While good for the containment of structural risks and the overall economy in the long-term, the rate hikes could have a negative effect on the asset markets in the short-term, especially if the markets get carried away with the new paradigm theme.
The end-game could well be a cyclically weaker global US dollar in the second quarter of 2000 and beyond, even though in the period straddling the new millennium, the greenback could maintain its perkiness against the euro. Asian import This soft-landing scenario for the US economy in 2000 will have significant policy implications for Asia. For much of the early part of the recoveryphase of the regional countries, net external trade (critically with the US) was the principal driver of growth. But that is changing as domestic absorption in Asia steadily picks up. The moderation in US growth will further accentuate this trend. It will intensify the resolve of Asian authorities to broad base their economic growth and generate sustainable local engines of growth. Sound policies will undoubtedly help towards this end. So would the prognosis for a weaker global greenback.
By enabling sever Asian monetary policy to a significant extent from that of the US, it will help regional central banks continue maintaining an accommodative bias deep into 2000. All this is another way of saying that there might yet be plenty of residual value in East Asian bonds for investors with a medium-term horizon, especially with inflation not deemed to be a significant worry. It is an outcome that applies to Indian fixed-income instruments too!
The author is senior treasury economist with Standard CharteredBank, India. These are his own views. He may be contacted at vasan. shridharan@in.standardchartered.com
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