Focus on Asia - Asia likely to benefit from the Fed’s significant change in stance

Author: Dr. John Greenwood (Chief Economist)

Q1) The latest FOMC statement was seen as a significant change from its stance in 2018. What is your outlook on Fed fund rate and Fed balance sheet? What would be the implications for Asia?

Dr. Greenwood: Yes, that is correct. In particular, the FOMC said that “In light of global economic and financial developments and muted inflation pressures, the Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate…” (Emphasis added). At the subsequent press conference Fed Chairman Jay Powell confirmed that this applied to both the trajectory for interest rates and the pace of the Fed’s balance sheet shrinkage. Financial markets have interpreted these statements – along with those by other FOMC members – to mean that instead of continuing to raise rates three or four times (as previously expected) the FOMC will now refrain from hiking rates in March, and may now only raise rates once or possibly twice during 2019.

In my view the Fed will raise rates twice in 2019 – most likely in June and September – but it will continue to shrink its balance sheet at a rate of $50 billion per month. Importantly, broad money growth in the banking system (M2 or M3) and in the shadow banking system continues to grow at a very subdued pace – about 4.0-4.5%. This is enough to support economic growth, but it is not high enough to raise inflation. The US economy will therefore continue to expand but inflation will remain subdued.

The impact on Asia is almost entirely favourable. Trade should start to pick up again after the US-China dispute has been settled, enabling smaller East Asian economies to boost their growth rates from their
current rather low levels. At the same time, the low inflation in the US means that there is little danger of a drastic upward re-adjustment of interest rates by the Fed. This should reduce the risk of economic
shocks from global interest rates.

Q2) Starting 2019, China has cut RRR and allowed banks to issue perpetual bonds to shore up capital. It also cut taxes. Do you think these moves could give a meaningful boost to the economy? What is your outlook on China’s fiscal and monetary policies?

Dr. Greenwood: Given the need for China to reduce leverage in the economy following a decade of rapid credit growth, I believe there is limited scope for the Beijing authorities to expand the economy by traditional macroeconomic measures (such as faster money and credit growth, reduced RRR, lower interest rates, PBOC loans, increased government expenditures, or easier financing conditions for home purchases). Such measures would add to leverage and enhance risks in the economy. I therefore expect only a limited boost to the economy from these kinds of measures in 2019.

In my opinion China would do better to adopt more micro-economic measures aimed at improving the efficiency of the economy, and especially the large public sector corporations (SOEs). However, although the government has made statements about helping the private sector, it is my view that the measures taken in this area will be limited. I therefore consider large scale stimulus policy measures to be unlikely during 2019.

Q3) Many investors are concerned about Australia – the Australian dollar, a proxy for China risk, has been under significant pressure while Australia house prices plunge further in January. What is your outlook on the Aussie and local property prices?

Dr. Greenwood: The performance of the Australian dollar is typically closely related to the performance of Australian commodity prices. However, with the price of iron ore – Australia’s top export -- holding up surprisingly well, the overall index of Australian commodity prices has actually risen during the past year.

Nevertheless, there has also been a perception that the housing market is due for a major correction because house prices have risen so much during the past few years, and borrowing levels in Australia are already very high so local buyers will not be able to support the market. That would leave Australian house prices dependent on purchases by foreigners. It is probably for this reason that the Australian dollar has weakened – whereas normally it should have strengthened. The basis for such a decline in the currency would be an expected reduction in capital inflows due to the fact that house prices have clearly peaked and may continue to fall for another year or more, so foreign capital inflows will weaken.

My view is that until China has a stronger recovery and commodity prices rise, we should expect the AUD to remain weak, and Australian house prices will continue to decline.

Q4) In Japan, while the economy is likely experiencing its longest expansion phase since the end of World War II, the Japanese government warned of heightened trade tensions, a slowdown in the Chinese economy, Brexit and the risk of a sudden spike in the yen. In your view, does Prime Minister Shinzo Abe’s administration still have policy tools to support the economy? Also, do you think there is actually a risk of deflation in Japan (the end-Dec 2018 CPI was the lowest inflation rate since October 2017)?

Dr. Greenwood: Japanese macroeconomic policy makers are facing major headwinds – in particular a declining and ageing labour force. Although productivity has grown at a modest rate since the GFC, the major policy initiative of the Bank of Japan (so-called QQE, started in April 2013 soon after Mr Abe became Prime Minister) has failed to raise inflation back to 2% on a sustained basis. In my opinion this failure of monetary policy is due to the poor design of QQE. Instead of buying securities from non-banks, which would have created new money in the economy and boosted spending, the Bank of Japan mainly bought securities from banks, which did not create new money and therefore did not boost spending in the economy. 

To put it another way, the money supply (M2) has only grown at 3% on average since 2010, whereas for 2% inflation I calculate that Japan needs at least 5%, possibly 6% M2 growth. I see no sign that the BOJ is going to change its strategy, and therefore it is unreasonable to expect Japan’s inflation rate to return to the 2% target. On the contrary, I expect inflation to continue to remain very low, and from time to time (especially if the yen is strong) there will be deflation – but not permanently.