TOKYO – Is Asia being complacent about the risk of assertive Federal Reserve tightening?
The answer looks to be “yes.” And that is worrisome. December 2021 is beginning to feel a lot like December 2015 as Chairman Jerome Powell prepares world markets for the Fed hitting the brakes – perhaps soon.
Markets seem oddly calm about the Fed turning hawkish. Perhaps irrationally so.
In more conventional times, governments would be directing banks to set aside more reserves and rainy day funds to hedge against upcoming turbulence. And central banks should be at the ready to calm markets.
In the region, there is no sign that policymakers are preparing for the worst.
“The ‘transitory inflation’ debate in the United States is over,” says Yale University economist Stephen Roach, formerly chairman of Morgan Stanley Asia. “The upsurge in US inflation has turned into something far worse than the Federal Reserve expected. Perpetually optimistic financial markets are taking this largely in their stride. The Fed is widely presumed to have both the wisdom and the firepower to keep underlying inflation in check. That remains to be seen.”
Nowhere is that optimism stronger than in Asia.
Then and now
No region was hit harder by the Fed’s shift toward austerity six years ago this month. That was back when Powell’s predecessor Janet Yellen hiked short-term interest rates for the first time in a decade. The move, of course, was preceded by two years of turmoil and angst in Asia’s markets, starting with the “taper tantrum” of late 2013.
For the region, though, there’s a big difference between then and now. In 2015, the world’s most powerful central bank was leading markets. Its move to normalize rates, post-2008 Lehman Brothers crisis, was a classic adult-in-the-room policy pivot.
Today, the Powell-era Fed is playing catch up. Markets decided that even if the vast majority of current inflation pressures can be tied to the pandemic, they will be more lasting than the Fed assumed. That goes, too, for Yellen, who’s now US President Joe Biden’s Treasury Secretary.
Yields on US 10-year securities are 1.44%, compared with 0.91% at the start of the year. It means traders are well ahead of Powell’s team in adjusting to the new monetary environment in which Washington finds itself.
Asia has been slower to react – and that could be a mistake.
The Powell Fed’s bite could be much worse than its bark. Risks are rising that markets will realize, sooner rather than later, that the supply-chain disruptions and mismatches between demand and the availability of goods may get even worse in early 2022 as the Omicron Covid-19 variant does its worst.
Policy banks lack levers
One challenge is that the Fed has almost no control over these dynamics. Nor can Powell or central bankers from Beijing to Frankfurt cajole the Organization of Petroleum Exporting Countries, or other energy-sourcing governments, to increase production.
Yet the cumulative effect of 13 years of monetary authorities holding rates at near zero is factoring into upward price pressures. Supply-chain snafus might be doing less damage if not for a decade-plus of too much central bank cash chasing too few productive uses. The combination is turning a classic overheating scenario up to 11.
It hardly helps that Powell appears to be arguing with himself. In recent days, he admitted his months-long argument that upward inflation pressures are “transitory” is no longer operational. At the same time, Powell told lawmakers that Fed policies have “adapted to that.”
As equity trader Michael James at Wedbush Securities notes, “Powell’s comments threw a monkey in the wrench in market thinking in terms of potential taper timing. You’re seeing as a result of that, risk-off across the board.”
Yet the shift toward deleveraging has been far less aggressive than in 2013 or 2015, which has economists like Roach worried.
The Fed has, to its credit, avoided a significant inflation mistake for arguably 25 years now. But then, neither Powell’s team nor its predecessors had ever dealt with a post-pandemic world as interconnected as trading systems are today. This has many economists worried that faith in the Fed is misplaced. This may have bred hubris in the Fed’s ranks, too.
“There is an added complication – the Fed’s belief in the magical powers of its balance sheet,” Roach says.
But the Fed, Roach adds, “must normalize in the face of an inflation shock.” This, he reckons, calls into question the glacial process envisioned in a low-inflation normalization scenario.
How will the Fed do the necessary?
Is the Fed failing to make this important distinction? As of now, it has telegraphed a mechanistic unwinding of the two-step approach it used in the depths of the 2008 crisis.
The Fed views normalization simply as a reverse operation – reining in its balance sheet first, then hiking the policy rate. In reality, it means taking the world’s biggest economy off of life support.
Not surprisingly, views on this are all over the place.
Take Mizuho Bank economist Vishnu Varathan. In explaining the way ahead to the bank’s clients, Varathan says, “We’ll get there fast and then we’ll take it slow.”
To him, this is “the framework for understanding the spate of hawkish comments and commentary dominating airwaves after solid US data.”
Varathan points to St. Louis Fed President James Bullard’s view that “a more hawkish direction” is appropriate given the emerging inflation risks.
It’s a disposition, he says, that “appears to resonate with many Fed watchers. But not so much because of a universal desire for aggressive tightening towards the end of far more restrictive policy settings. Rather, it is so that a stitch in time saves nine.”
Simply put, Varathan notes, the collective sense that the Fed will “get there fast and then take it slow” explains why US Treasury yields “were not unduly triggered.”
Many investors are seeing silver linings in Fed tightening moves, so long as they’re gradual, orderly and sufficiently telegraphed. As the dollar edges higher, for example, there’s hope that Asia’s export-dependent economies might benefit from lower exchange rates.
As strategist Alvin Tan at RBC Capital Markets points out, “Asian FX have held up really well in this latest risk-off bout.” The Japanese yen, for example, is down 9% this year versus the dollar.
The Chinese yuan, meantime, has been more stable, in part because Beijing is actively working to avoid movements that might spook markets. There’s also the issue of dollar-bond payments due in the weeks and months ahead. The default risks hovering over China Evergrande Group, Fantasia Holdings, Kaisa Group and other developers might increase if overseas bond payments become harder to make.
President Xi Jinping’s government also fears importing inflation.
In October, China’s factory gate inflation hit a 26-year high amid surging oil and coal prices and a domestic crunch in industrial regions of Asia’s biggest economy. It’s a clear sign that “manufacturing is now also feeling the heat,” says economist Craig Botham at Pantheon Macroeconomics.
Even Japan is experiencing a whiff of inflation. Japanese wholesale prices hit a four-decade high in October, surging 8% year-on-year amid surging energy costs and a weaker exchange rate. While many in Japan would like to see some inflation across their economy, what they have got is the bad kind of inflation – the kind that dents consumer and business confidence.
Fuel jumped 44.5% in October from a year earlier and timber goods were up 57%. “If the economy continues to recover,” says Atsushi Takeda at Itochu Economic Research Institute, “firms may be able to pass on costs at some point.”
US inflation is far worse, though, having already filtered through to finished prices. The 6.2% rise in consumer prices in October was the sharpest since November 1990.
And that is forcing the Powell Fed’s hand in ways that could make 2022 a more chaotic year for Asia than markets appear to realize.