The ‘great divergence’
Monetary policy is a powerful weapon in an economic battle. It is a fast and effective policy means to tame runaway inflation. It does not require a new government budget or a separate law. The central bank can independently adjust a benchmark interest rate and monetary supply.
Major central banks moved fast to shave interest rates and print new money to bolster liquidity and artificially create capital demand following the financial meltdown in 2008. The U.S. Federal Reserve brought down the overnight lending rate to near zero percent and employed an unconventional tool called “quantitative easing” by purchasing bonds from private and public institutions. The central banks of the European Union, the UK and Japan ran similar programs. Easy and cheap liquidity flooded out, helping to inflate stock and real estate prices and boost consumption and corporate investment. Due to consequent fall in major currencies, exports became cheaper. The fight with a global financial crisis was won thanks to concerted, ultra-loose monetary policy.
The economic environment has greatly changed in 2016. The central banks of global economic powers have gone separate ways in their approaches to monetary policy, causing what is now dubbed as the “great divergence.” The U.S. Federal Reserve “lifted-off” interest rates from near zero percent by raising its base rate by 25 basis points in December. The Fed is expected to hike rates a few more times this year. With members on the Federal Open Market Committee turning more hawkish to stabilize consumer prices, the tightening pace could accelerate.
The European Central Bank (ECB), in the face of stubbornly depressed demand, decided to continue with the unconventional bond-purchase program until 2017. Meanwhile, the Bank of Japan extended the maturity on government bonds and is expected to introduce another round of quantitative easing this year. The Chinese central bank has devalued the local currency and eased financial loan requirement to aid exporters and domestic demand.
Volatility in the global fund market is inevitable with capital chasing profits from the decoupling of interest rates in major economies. The U.S. dollar will appreciate further and the euro, yen and yuan are headed for roller-coaster rides. As in 1982 and 1994, when U.S. interest rates went decisively north, emerging markets with poor underlying fundamentals could be shaken by exoduses of foreign funds. In December, central banks in emerging economies went different ways with Thailand and New Zealand lowering their interest rates while Mexico and Chile raised theirs.
The mixed external conditions place the Bank of Korea in a conundrum. Last year, the only worry was when it should lower the key interest rate. There were calls for monetary policy to help stimulate domestic demand. Inflation was no worry due to depressed oil prices. The base rate has been lowered to a record low of 1.5 percent.
The Bank of Korea now has three options. It will have to deliberate whether to keep the rate unchanged or push it higher or lower. A hasty rate hike could further dampen consumer and corporate spending and depreciate the currency. The Korean currency cannot be left to strengthen on its own while currencies of its neighboring export rivals are weakening. Downside risks like a harsher-than-expected economic slowdown in China, geopolitical tensions and sluggish domestic demand could increase pressure to push interest rates lower. We have learned from our neighbor Japan that a sudden turnaround to monetary tightening can trigger a popping of asset bubbles and a putting of the entire financial system at risk. That is what sent Japan into its so-called lost decade, which is actually two decades. We cannot march into the same quagmire.
But keeping interest rates low for a long time can also generate many side effects. Household debt has snowballed and weak companies are surviving entirely on debt. Financial imbalances also have worsened. Although the inflation hovered way below the target rate at 0.7 percent last year, it is expected to hit above the target rate of 2.0 percent this year depending on oil and farm produce prices.
When international rates go higher and local economic conditions improve, the BOK would inevitably have to mull pulling up the key interest rate. Coordinated policy-maneuvering from the government and financial supervisory authorities is essential to make the transition smooth. The economy must recover through fiscal policy and structural reforms. Deleveraging of household debt and a clean-up of “zombie” companies must take place to minimize the shock on the economy when the time comes for normalization of interest rates. When the economy strengthens, higher rates would be welcome.
Central banks around the world have entered uncharted waters. But they must keep neutrality and operate monetary policy in a pre-emptive way. The unconventional quantitative easing program introduced by former Fed Chairman Ben Bernanke was criticized for having helped ailing financial institutions more than consumers, but few would disagree that it contributed in the U.S. battle with its worst financial and economic challenge since the Great Depression. Paul Volcker who became the Fed chairman in 1979 when inflation was hovering at 10 percent boldly raised the Fed rate to 20 percent. People protested violently in front of Fed headquarters, but he did not yield until inflation was in check.
The central bank must be responsive to overseas factors, accurate in economic assessments, in synch with financial authorities, and most of all in tune with the markets this year. We hope to see an artful monetary policy this year.
Translation by the Korea JoongAng Daily staff.
JoongAng Ilbo, Jan. 9, Page 31
The author is an economics professor at Korea University.
by Lee Jong-wha