Risks of normalized interest rates

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Risks of normalized interest rates

The world is holding its breath as it awaits a critical meeting by the U.S. Federal Reserve on Sept. 17 that could change the direction of U.S. short-term interest rates for the first time in nearly a decade. Opinions are mixed, with some saying it’s too early for the Fed to shift into a contractional mode by lifting the Fed rates, which have hovered near zero since 2008, given ongoing financial turbulence.

About seven out 10 experts place bets on the Fed staying pat on interest rates for September. The U.S. Fed turned outright expansionary after Wall Street giant Lehman Brothers went bust in 2008, causing a financial meltdown across the globe. The Fed lowered the benchmark Fed rate to zero percent in December that year in order to stabilize the financial market and boost the economy. When that wasn’t enough, the U.S. central bank resorted to quantitative easing, under which it bought large amounts of financial assets from financial institutions and long-term treasuries to boost money supply. U.S. monetary authorities announced its tapering-off of the program and stopped the purchase of bonds last year. What will come next is an increase in interest rates.

The logic behind the inevitability of the U.S. interest rate heading north is backed by fast economic recovery. The government estimated the economy grew at a solid 3.7 percent annual rate in the second quarter and expected the pace to exceed 3 percent for a full year in 2015 and 2016.

Federal Reserve Vice Chairman Stanley Fischer recently indicated that the Fed might raise interest rates before inflation is closer to the 2 percent target by saying that key factors holding down inflation have already began to fade. The central bank must consider the risk of assets gathering bubbles if debt-financed investment from easy liquidity is kept unattended for long.

But moderates warn the U.S. economy is still too fragile and mixed to suggest it is on a sound recovery path. If rates go up, domestic spending could be hurt and the higher dollar value could also darken export prospects.

Decreased demand from the world’s second-largest economy due to a faster-than-expected slowdown in the Chinese economy and low oil prices also would discourage a rise in consumer prices. They argue that a preemptive rate hike while the U.S. and global economies remain uncertain could only aggravate volatility.

But both investors and experts generally agree that global factors are not perilous enough to change the Fed’s course, even if it could push back the timing of the first hike from September to December.

Economies around the world are fully aware of the direction in U.S. monetary policy. What’s important to emerging economies like ours is how to cope with the change when it actually takes place. The Fed has assured us that the pace and scope of the hike will be moderate. But any monetary action from the Fed could affect global markets.

Massive funds from synchronized quantitative easing from the United States, Europe and Japan that had flowed into the emerging economies have already been exiting fast, raising volatility in financial and foreign exchange markets and undermining asset prices in emerging economies. If international rates and dollar value rise, borrowing costs in companies, financial institutions and governments with heavy dollar loans will inevitably increase.

The IMF parsed the effect of the U.S. rate hike on Asian economies in its report in April on outlook and policy challenges for Asia and Pacific in terms of economic fundamentals and correlation with global financial and trade conditions. In the report, it predicted Korea will be the least hurt. But this is no comfort.

The Korean economy is weighed down by astronomical household debt and large corporate borrowings from overseas. Moreover, the economy moves in sync with China. The local central bank would be at its wit’s end if U.S. and Chinese monetary policy go in opposite directions. Monetary, currency and fiscal policy tools must be used with greater agility and dexterity. At the same time, authorities must monitor household debt to keep the financial system stable.

The Bank of Korea in June held an international forum on the normalization of international rates and challenges for monetary policy. BOK Gov. Lee Ju-yeol emphasized on the need for greater risk control through strengthening in economic fundamentals and macroeconomic integrity as well as inter-government cooperation to bolster common buffers against dangers through means such as currency swaps.

Currency swaps that allow central banks to trade currencies at preset exchange rates can be of great help during crisis. Although the country has sufficient foreign exchange reserves and short-term foreign borrowings aren’t that great, Korea could be better insured if it has currency swap agreements with the major central banks of America, Japan and Europe. The normalization of interest rates means the world’s largest economy is getting better. But the transition has increased risks and uncertainties. We must be prepared to take preemptive action against any possible dangers to minimize the ill effects on the local economy.

Translation by the Korea JoongAng Daily staff

JoongAng Ilbo, Sept. 4, Page 31

*The author is an economics professor at Korea University.

by Lee Jong-wha

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