The following article was published in Peking University HSBC PFR, written by Zhang Ming.
The Federal Reserve has started the process of raising interest rates and shrinking its balance sheet since March 2022, and the year-on-year growth rate of U.S. CPI has increased from 90% down to 32%, the inflation rate has fallen significantly. The year-on-year growth rate of both CPI and core CPI is still significantly higher than the Fed's monetary policy target.
In response to the future Fed interest rate hike process, Zhang Ming, deputy director of the Institute of Finance and Economics of the Chinese Academy of Social Sciences and deputy director of the National Finance and Development Laboratory, wrote in the "Peking University Financial Review" that the Fed is likely not to raise interest rates in the future. However, considering that the year-on-year growth rate of core CPI is unlikely to fall to around 2% in the short term, this means that the probability of the Fed switching to rate cuts is low, at least in the first half of 2024. This means that the global economy and financial markets will continue to have to operate at very high short- and long-term interest rates for at least the next six months.
The full version of this article will be published in the 18th issue of Peking University Financial Review.
For a long time after the outbreak of the global financial crisis in 2008, the world economy was in a state of secular stagnant characterized by "three lows and one high" (low growth, low inflation, low interest rates, and high debt). However, from 2021 onwards, the US inflation rate began to climb rapidly and reached 90% peak. At the same time, advanced economies such as the European Union and the United Kingdom are also facing rising inflationary pressures.
The factors that cause this round of inflation are roughly the supply side, the demand side, the policy side and the deep-seated causes.
From the supply side, the outbreak of the new crown epidemic in 2020 caused the interruption of the global industrial chain, resulting in a supply-side shockThe Russia-Ukraine conflict that erupted in 2022 significantly boosted global commodities**. On the demand side, after the outbreak of the new crown epidemic, developed countries such as the United States have implemented unprecedented and extremely loose fiscal and monetary policies. In particular, large-scale fiscal subsidies for households have raised the temporary income of the household sector and pushed up short-term demand. From the policy side, in the context of long-term low inflation, in August 2020, the Federal Reserve announced that it would revise its monetary policy rules to implement a long-term target of an average inflation rate of 2% instead, which means that the Fed will strengthen its tolerance for rising inflation in the short term. In addition, for a long time after the significant rise in inflation in the United States, the Federal Open Market Committee still judged that this round of inflation was transitory, mainly due to the supply-side shock caused by the epidemic, so there was no need to immediately shrink monetary policy.
However, there is a deeper reason behind this round of inflation, that is, the once-soaring globalization has gradually decelerated and even reversed after 2018. In March 2018, the Sino-US war broke out. From 2020 to 2022, the new crown epidemic was raging, and after the end of the new crown epidemic, as major developed countries pursued the resilience and controllability of the industrial chain, the global industrial chain has become fragmented. Both of these events imply headwinds for globalization, which will undoubtedly reduce the efficiency of the allocation of resources on a global scale, thereby raising the cost of production of various products and services, and ultimately gradually pushing up the inflation hub.
As inflation levels are significantly higher than the central bank can afford, the Fed has started the process of raising interest rates and shrinking its balance sheet since March 2022. So far, the Fed has raised interest rates 11 times in a row, with a cumulative increase of 525 basis points. In contrast, the ECB started raising interest rates in July 2022 and has raised interest rates 10 times in a row so far, with a cumulative increase of 450 basis points: the Bank of England has raised interest rates since December 2021 and has raised rates 14 times in a row so far, with a cumulative increase of 515 basis points. It is very rare in history for the banks of the three advanced economies** to raise interest rates so steeply in such a short period of time. In addition, the Fed began to shrink its balance sheet in June 2022, reducing its balance sheet by $47.5 billion per month for the first three months and $95 billion per month thereafter.
What is the outcome of the Fed's interest rate hike?The answer is unsatisfactory. On the one hand, as a result of continuous interest rate hikes and balance sheet reduction, the inflation rate in the United States has indeed declined significantly, and the year-on-year growth rate of CPI has increased from 90% down to 32%。On the other hand, the year-on-year growth rate of core CPI, which the Fed is more concerned about, showed stronger stickiness, only from 6. in September 20227% down to 4. in October 20230%。The year-on-year growth rate of both CPI and core CPI is still significantly higher than the Fed's monetary policy target.
In order to understand why the US CPI growth rate is sticky, we break down the US CPI basket into three parts: goods, services and rents. The data shows that as of October 2023, the year-on-year growth rate of goods** has dropped to 04%, and the year-on-year growth rate of services** is still as high as 51%, and the year-on-year growth rate of rent** is as high as 67%。The fundamental reason why U.S. services** and rents remain high is that the U.S. labor market is still tight. The U.S. unemployment rate in October 2023 is only 39%, which means that the labour market is still in short supply, and the pressure on wages** is still high, which will undoubtedly push up services and rents**. In other words, until the U.S. unemployment rate deteriorates significantly, the U.S. CPI growth, especially the core CPI growth, will remain sticky.
What will be the future of the Fed's interest rate hike process?In fact, the Fed has raised interest rates only once since June 2023. At the June, September, and November interest rate meetings, the Fed stopped raising interest rates, and only announced a 25 basis point rate hike at the July meeting. In other words, the pace of Fed rate hikes has slowed significantly since June 2023. The author's ** is that the Fed is likely not to raise interest rates in the future. However, considering that the year-on-year growth rate of core CPI is unlikely to fall to around 2% in the short term, this means that the probability of the Fed switching to rate cuts is low, at least in the first half of 2024. This means that the global economy and financial markets will continue to have to operate at very high short- and long-term interest rates for at least the next six months.
Since the Fed launched the current round of interest rate hike cycle in March 2022, there have been financial crises of varying degrees in emerging markets and developing countries such as Sri Lanka, Pakistan, Lebanon, Turkey, Egypt, Ghana, Zambia, and Argentina. The trigger for the crisis was short-term capital outflows caused by the Fed's rapid interest rate hikes. Short-term large-scale capital outflows have led to the depreciation of local currency exchange rates, the intensification of external debt burdens, and the pressure on domestic assets and financial institutions.
In the second quarter of 2023, a round of banking turmoil broke out in Europe and the United States. To date, three 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 both mid-sized banks ranked 10th to 20th in the United States. The common reason for the failure of these three banks was that their assets bought large quantities of Treasury bonds and high-grade agency bonds. The market value of these bonds has shrunk significantly against the backdrop of a rapid rise in benchmark interest rates, a phenomenon that has sparked anxiety among depositors, who voted with their feet to start a run that culminated in a classic banking crisis. It was only after a joint bailout by the US Treasury, the Federal Reserve, and the Federal Deposit Insurance Corporation that the crisis did not further expand. Credit Suisse and Deutsche Bank in Europe were also embroiled in the crisis. In addition to the floating losses on the asset side, these two banks also have serious corporate governance problems.
Considering that short- and long-term interest rates in the United States will remain running at very high levels for some time to come, will this lead to new risks?There are two potential risks that the U.S. market is currently more worried about. First, the U.S. corporate bond market, especially the high-yield corporate bond (junk bond) market, has greater potential risks. The rise in the risk-free rate and risk premium will significantly increase the pressure on companies to repay debt and interest, and it is unclear whether they will face collective defaults in the future. Second, the U.S. real estate market, especially the commercial real estate market, is facing adjustment pressure. A rise in the benchmark rate pushes up the interest rate on real estate mortgages, which causes the housing market to correct. The pandemic has changed the way SMEs work to some extent, and the rise of remote work has reduced the demand for commercial real estate to buy and lease, so the commercial real estate market is facing significant adjustment risks.