The impact of monetary policy tightening by the US and European central banks

(The author of this article is Zhang Ming, Deputy Director of the Institute of Finance and Banking, Chinese Academy of Social Sciences, and Deputy Director of the National Finance and Development Laboratory)

Let me briefly talk about the causes of the current round of high global inflation, the results of the current response of central banks, and the possible future trends.

The current round of global high inflation probably began in 2021, and the inflation rate has exceeded most people's expectations. In terms of causes, there are four main aspects:

First, from the perspective of supply, the global economy has faced two supply-side shocks, the new crown epidemic and the Russia-Ukraine conflict, which will undoubtedly push up the inflation level;

Second, from the demand side, after the epidemic, the U.S. government implemented an unprecedented and extremely loose fiscal and monetary policy, and other major countries have followed suit. In particular, the expansionary fiscal policy has a direct effect on households, raising their temporary incomes;

Third, from a policy perspective, why has the Fed's response been relatively slow even after the inflation level has risen this time? One of the reasons is that the previous long-term low inflation caused the Fed to change its monetary policy rules and change the inflation targeting system to the average inflation targeting system before the current round of high inflation. If the CPI growth rate has been below 2% for a long time, then it can be tolerated that the CPI growth rate will be higher than 2% for a period of time after that. The second reason is that most Fed policymakers believe that this round of inflation is a temporary shock and the effect will not last.

Fourth, the deeper reason for this round of inflation is actually the wave of anti-globalization since 2016. There are two events that have clearly pushed up global inflation. One is that the US-China trade friction has led the US to reduce imports from China in favor of imports from elsewhere, which are significantly more costly. The second is that there is a new trend of fragmentation in the global supply chain after the new crown epidemic, which will reduce the efficiency of resource allocation and push up global production costs.

The above are the four causes of this round of high global inflation, namely the supply side, the demand side, the policy side and de-globalization.

Since March last year, the Fed has embarked on a very steep process of raising interest rates and shrinking its balance sheet. So far, the Fed has raised interest rates by 525 basis points 11 times, the European Central Bank has raised interest rates by 450 basis points 10 times, and the Bank of England has raised interest rates by 515 basis points 14 times. Such steep interest rate hikes by the three major central banks in a short period of time have not occurred in many years. In particular, the Fed raised interest rates four times by 75 basis points from June to November last year. The cumulative magnitude of these four rate hikes is equivalent to the cumulative magnitude of the past 12 rate hikes, which can be described as very steep.

What will be the outcome of the rate hike? The answer is unsatisfactory. The year-on-year growth rate of US CPI slowed from 9.0% in June 2022 to 3.2% in October 2023. However, the core CPI growth rate that the Fed is more concerned about fell from a peak of 6.7% year-on-year to 4.0% in October 2023, still well above the target of 2.0%.

Why does the year-on-year growth rate of the US core CPI seem to be less likely to come down? We break down the CPI into three parts: goods, services, and rents. At present, commodity prices have completely come down, and in fact they are already negative. But the decline in the price of services has been very modest, while the price of rent has not fallen at all.

Why can't the price of services and rents come down? This is highly related to the fact that the current US labor market is very tight, the supply of labor exceeds demand, and the upward pressure on wages and salaries is greater.

We conclude that without a significant deterioration in the U.S. labor market, it is unlikely that the year-on-year growth rate of core CPI in the U.S. will slow to around 2% in the near term. So far, few people believe the Fed will cut rates in the first half of next year. In other words, the global economy and financial markets will remain operating at high short- and long-term interest rates for at least the next six months. The US federal funds rate is now at 5.25-5.%5 and the 10-year Treasury rate is around 4.5%, both of which are the highs of interest rates in the past 16 or 7 years.

What is the impact of central banks in developed countries raising interest rates collectively and shrinking their balance sheets?

From March last year to the first quarter of this year, there were about eight emerging markets and developing countries around the world that experienced financial crises of varying degrees due to short-term capital outflows. It is characterized by depreciation of the local currency, an increase in foreign currency debt, and a decline in domestic asset prices due to short-term capital outflows. If the country's financial system is fragile, it is prone to financial crises. These countries include Sri Lanka, Pakistan, Lebanon, Turkey, Egypt, Ghana, Zambia and Argentina.

In the second quarter of this year, the crisis returned to the core countries of Europe and the United States, and the banking industry in Europe and the United States was in turmoil. Three commercial banks in the United States have failed: Silicon Valley Bank, Signature Bank, and First Republic Bank. Among them, Silicon Valley Bank and First Republic Bank are the 10th-20th mid-sized banks in the United States. The common reason for the collapse of these three banks was that the asset side invested a lot of US Treasury bonds and high-grade agency bonds, which caused huge paper losses against the backdrop of a sharp rise in US interest rates. Credit Suisse and Deutsche Bank are also involved in crises in Europe, and European banks are generally weaker than US banks in terms of corporate governance, with the exception of capital losses due to rising interest rates.

Considering that short- and long-term interest rates will remain high in the next six months, where are the potential risks in the next stage?

The first is the U.S. corporate bond market, especially the high-yield corporate bond market, also known as the junk bond market. Because of its high financing costs, it may be overwhelmed if both the benchmark interest rate and the risk premium go up.

The second is the U.S. real estate market, especially the commercial real estate market. At present, the average 30-year mortgage interest rate in the United States is 6-7%, which is very high. The commercial real estate market is under more pressure to adjust. In the wake of the pandemic, U.S. businesses have adjusted their office models, and many companies have found that working from home does not significantly affect efficiency, so the rental demand for commercial real estate has declined. States such as California and Florida, which have a large number of commercial real estate, are currently under more pressure to adjust.

Third, the government debt pressure of major countries will rise significantly in the future. In the past, the world economy was "three lows and one high", that is, low growth, low prices, low interest rates, and high debt. Since high debt is formed in a low-growth, low-interest rate environment, there is little pressure to maintain it. But now the world economy has become "three highs and one low", and although economic growth is still low, prices and interest rates have risen. In this environment, high debt becomes unsustainable.

Why has the government debt problem not been exposed so far? Quite simply, because in the past these countries have issued long-term bonds. Although market interest rates have risen significantly, as long as long-term bonds do not mature, current interest rates will not affect corporate interest payment pressure. But starting next year, many countries will start to have a large number of government bonds maturing, and the interest rate on new bonds will be as high as 4-5% next year. In the coming period, on the one hand, the debt service pressure of developed countries such as Japan and the United States will increase significantly, and on the other hand, the debt pressure of African heavily indebted poor countries will become more unbearable.

Finally, I would like to talk about the impact of the collective interest rate hikes and balance sheet reduction of central banks in developed countries on China's economy. I think that China's external environment will be generally better next year than this year. From a balance-of-payments perspective, I think in 2024, China's current account will remain under pressure, but its financial account will improve significantly. On the one hand, the pressure on the trade side is still relatively large, first, because of the decline in external demand, second, because the United States has import restrictions on us, and third, with the marginal improvement of Sino-US relations, we have begun to accelerate the import of agricultural products from the United States. On the other hand, we have faced relatively large short-term capital outflows this year, and FDI faced a net outflow in the third quarter of this year. However, with a series of recent policy adjustments in China, the author believes that China's economic growth situation will be better next year than this year, FDI will flow back in, and the situation of short-term capital outflow may also improve.

With the combined effect of the above two aspects, we are more optimistic about the RMB exchange rate next year. Recently, the closing price of the renminbi against the US dollar has rebounded significantly, indicating that the market's depreciation expectations are revising. We believe that the RMB exchange rate against the US dollar should rise steadily against the backdrop of two-way fluctuations next year.

(This is a transcript of the author's speech at the inauguration ceremony of the Institute of Global Governance and Development of Chinese University of China and the Global Governance and Development Forum (2023) on November 23, 2023.) The views expressed in this article are solely those of the author)