Forget tapering of quantitative easing (QE). Financial markets are no longer fearful of the gradual winding down of the US Federal Reserve’s monthly asset purchases. But investors and bankers alike are now pondering the prospect of the normalisation of US monetary policy. While QE measures have come and gone, the next US interest rate increase will be the first since 2006.
In the aftermath of the subprime mortgage crisis, the world’s largest central bank made a series of reductions in its Federal Funds rate to combat a recession. And in December 2008, it established a historically low target range of zero to 0.25% for the policy rate, which is still in place. Essentially, banks can borrow at (near) zero cost. But this era of ultra-loose monetary policy and super-cheap liquidity is coming to a close.
As the US economy picks up, Fed officials will need to move the policy rate to a more normal level. In the June meeting of the Federal Open Market Committee (FOMC), one participant expressed the view that the rate would rise this year. Three said an increase wouldn’t happen until 2016, but 12 agreed on 2015.
We expect the initial increase around June or July of 2015, and no sooner than that, because the Fed still needs time to achieve its two mandates: maximum employment and price stability.
Even though the unemployment rate, at 6.1% in June, continues to fall steadily, US inflation has run persistently below the Fed’s 2% objective. It takes time to build momentum for a sustained increase in price levels of goods and services, and the evidence may not be clear-cut until the economy has gained adequate traction.
Global transmission of monetary tightening: Changes in interest rates in major economies tend to have important effects on other countries. A National Bureau of Economic Research paper published in 2002 confirms this. Drawing on a large sample of data during 1970-99, Jeffrey Frankel of Harvard University and colleagues from the World Bank show a relationship between international and domestic interest rates in both industrialised and developing economies.
For Thailand, the researchers found that an increase of one percentage point in the US T-bill rate would raise local money market interest rates by roughly the same amount. Half of that transmission usually would be completed in a month or so.
Our own in-house investigation shows a similar link between policy interest rates. The decisions of the Bank of Thailand’s Monetary Policy Committee (MPC) show a strong positive relationship with those of the FOMC, at least under normal circumstances.
Since the beginning of the millennium, the Thai one-day repurchase rate has more or less tracked movements of the Federal Funds rate, but seemingly not in a linear manner. The relationship broke down somewhat during the dot-com bust in the US, and ever since the Fed adopted its ultra-low target range.
While the reasons underlying the MPC’s behaviour may be difficult to pinpoint – e.g. monetary policy synchronicity is probably perceived as crucial in order to guard financial stability – we have identified an explicit channel in which global transmission takes place. And since local banks usually adjust their rates following a domestic policy rate change, Fed normalisation would mean rising borrowing costs in Thailand too.
Our econometric analysis suggests a rise of 25 to 50 basis points (bps) in the Thai policy rate toward the end of 2015 in response to a rise of 100 bps in the US rate that most Fed members expect next year, likely in increments of 25 bps starting around midyear.
An additional rise of 100 to 150 basis points in the US rate during 2016 will have a stronger impact on the Thai policy rate, which should rise by a similar magnitude by end-2016. This is due partly to residual effects from the initial hikes which took some time to transmit.
When the US policy rate reaches the 4% projected target in the longer term, its Thai counterpart might level off around 4% or slightly less. This is because, historically, when the US rate was relatively high, the Thai rate was lower. But in any case, that’s not going to happen any time soon.
Forex volatility will precede rate hikes: While the transmission of interest rates may appear measured, behaviour in the foreign-exchange market is less even.
Fed chairwoman Janet Yellen’s infamous “six months” comment in March, for example, led to a rout in some financial markets. The dollar rose immediately after she said the Fed would keep its benchmark rate low for a “considerable time” after QE ended – which “probably means something on the order of around six months”.
Her predecessor Ben Bernanke caused similar upset during his tenure. As we have noted in previous columns, Bernanke-related fear of QE tapering, since mid-2013, occasionally brought about massive capital outflows from emerging Asia, and rapid weakening of many Asian currencies – and they happened eight months in advance of actual tapering. Déjà vu.
The impact of Fed policy normalisation on the baht is therefore on a whole other level. In this case, perception usually matters more than reality – dependent on news and cues. Any strong data from the US — a faster-than-expected fall in unemployment or a larger-than-normal jump in inflation — could prompt more speculation about premature monetary tightening.
It simply requires Janet Yellen to make another slip of the tongue for the Thai baht and stock market to go wild. And there is no forward guidance for those signals.
TMB Analytics is the economic analysis unit of TMB Bank. Behind the Numbers is co-authored by Benjarong Suwankiri and Warapong Wongwachara. They can be reached at tmbanalytics@tmbbank.com