[The Editors' Verdict] Orderly Normalization of Monetary Policy

Kim Kyung-soo, Professor Emeritus at Sungkyunkwan University

One of the significant achievements of modern economics is viewing the ripple effects of policies as the result of a strategic game between policymakers and the private sector. Private decision-making depends on expectations about what policies the authorities will implement, and the authorities choose policies considering the expectations formed by the private sector.

Communication by policymakers sequentially influences expectations and then market variables. When communication is consistent with market variables, trust in the policymakers is established, enabling orderly market adjustments as intended by the authorities.

Currently, global financial markets are focused on messages from the U.S. Federal Reserve (Fed) regarding the direction of monetary policy. This year, as the pace of economic recovery accelerated and inflationary pressures increased, U.S. Treasury yields, which had soared, have been declining since May. The decline in Treasury yields is due to the downward stabilization of expected inflation.

The massive spending by the Democratic government, which recorded the highest level of federal government debt since the Korean War (102% of this year’s GDP), and the Fed’s asset purchases amounting to $120 billion per month under zero interest rates have sparked inflation debates. Nevertheless, expected inflation appears to be stabilizing downward. Investors have sided with the Fed’s claim that inflation is a temporary phenomenon caused by pent-up consumer demand.

Unlike the post-global financial crisis period, when a fiscal tightening stance was adopted, a reflation trade has occurred, where the inflation gap from expansionary fiscal policy has stimulated investment in risk assets. This has led to a resumption of asset market strength driven by leveraged investments. The U.S. Consumer Price Index released last week for June recorded the highest increase in 13 years, unexpectedly. Inflationary pressures are growing over time.

The fundamental skepticism about whether inflation will persist stems from doubts about whether the Fed can lead an orderly adjustment. The low interest rates that lasted more than a decade after the global financial crisis peaked during the COVID-19 crisis. Moreover, unlike during the global financial crisis, most countries, regardless of being advanced or emerging, pursued expansionary fiscal policies. According to the Institute of International Finance (IIF), global sovereign debt in 2020 (105% of GDP) increased by 17% compared to the previous year. Debt did not only increase for governments. Over the past decade, household and corporate debt have also surged significantly. According to the Bank for International Settlements (BIS), private debt relative to GDP has increased by more than 100% in China and over 50% in South Korea compared to the global financial crisis period.

Therefore, unlike before when other central banks followed the Fed’s moves, many advanced country central banks, excluding the European Central Bank (ECB), as well as emerging markets, have returned to monetary policy normalization mode. The Bank of Japan (BOJ) has ended quantitative easing, and the Reserve Bank of Australia has started tapering. The Bank of Canada began tapering in March, and the Bank of England in May. Among advanced countries, Norway has announced interest rate hikes in the second half of the year, and emerging markets such as Turkey, Brazil, Russia, and Mexico have implemented rate increases. Although variant viruses could be a variable, if inflationary pressures do not subside as many experts claim, debates over the timing of the Fed’s tapering will intensify. Last week, Fed Chair Jerome Powell stepped back by stating that the Fed is prepared to intervene if inflation becomes uncontrollable. However, if this timing is brought forward, orderly market adjustment will be more difficult, and the pain for highly leveraged countries will inevitably increase.

This content was produced with the assistance of AI translation services.