Expect rising interest rates, gently

Monetary policy governing interest rates in the global economy will soon change toward a northward direction. To understand this well, it is useful to refer to the main driver of world interest rates – the monetary policy in the most advanced economy – the United States.

US Fed announcement

In a remarkable statement last month, Jerome Powell, the chairman of the US Federal Reserve System, made a carefully calculated assessment of the direction of monetary policy for this year.

Speaking before the press at the conclusion of the two-day meeting of the Federal Open Market Committee, he said: “The committee is of a  mind to raise the federal funds rate at the March meeting assuming that the conditions are appropriate for doing so.”

Although Powell’s pronouncement was made with a major qualification, he was in fact essentially making an announcement that the US Fed is now changing from easy money toward a tighter monetary policy. The Fed is of the view that the labor market has reached a favorable position where wages are high and employment is at a peak level. The impending task is to tame the inflation rate, which has risen unexpectedly.

In fact, the US Fed now definitely signals that it is ready to raise interest rates and will begin to tighten liquidity, in part to put a lid on inflationary pressures in the economy.

More than a decade of easy money

Easy money policy has characterized the tone of  US anti-recession economic policy. Since the start of the financial meltdown of 2008 – the Great Recession – the stimulus for economic recovery has become basically more centered from monetary policy than from fiscal policy. Although there was strong need for fiscal policy intervention in times of a weak macroeconomic imbalance, the US political climate could not support a strong fiscal spending stimulus.

The Trump years introduced a tax cut for big corporations that stimulated investments and economic growth rate, which the recession fighters thought was inadequate. To stabilize the economy from the downturn, monetary stimulus was needed to supplement the inadequate fiscal spending.

That led the central bank, under the guidance of Mr. Powell’s immediate predecessors as chair in the FED, Ben Bernanke and Janet Yellen (now the Treasury Secretary under President Biden), to initiate and sustain a large and innovative program of bond-buying from the corporate private sector of the economy. This program is known as “quantitative easing” – QE in short – which Powell’s Fed continued.

Along with the near-zero interest rate policy, this program filled the needed stimulus gap in the American economy that enabled the economy to slowly recover.

The Fed funds rate is a traditional and powerful tool of central banking. This rate enables the country’s financial institutions, such as banks and credit unions, to lend their reserve balances to other institutions to finance use overnight financial shortages to enable the markets to transact.

During times of severe crisis, the rates could be brought down to as low as possible to influence more growth, investments, and ultimately more employment. Raising the rate could have the opposite effect of holding back demand.

The severity of the financial crisis led the US central bank to drive the interest rate in the US economy to almost zero level for almost a decade. Along with a substantial bond-buying program to inject direct liquidity in the private corporate sector, the US economy returned to a path of growth.

The Fed was already on the path of raising interest rates slowly from 2017 and this had reached around two percent when the COVID pandemic hit. The Fed reduced interest rates back to almost zero by April 2020 and has been held in that low range even today.

This is the base from which current discussion of an increase in interest rates is contemplated as the Fed prepares for its March meeting in two months.

The global scene

Countries have their own central banks and follow their own priorities. However, one essential element in their strategies is that they monitor and sensitize their policies to what the US central bank is undertaking. They calibrate their own interest rate policies to that taken by the US Fed.

It is natural for them to take US rates as a reference point. It is not a surprise that most interest rates across the globe are low at this point in time, but that they are likely to rise in unison after the US Fed moves them by March.

To enable the international financial market to function well therefore, the policies set in the most powerful economy often sets the tone for the others to follow. Hence, many central bankers pay attention to the leading central bank, in this case, the US Fed.

Prospects  for Philippine interest rates

The monetary policy stance of the Bangko Sentral keeps the following interest rates steady: The overnight borrowing rate at 2.00 percent. This is the midpoint between the deposit rate of 1.5 percent and the lending rate of 2.5 percent.

Like most emerging market central banks, the Philippine borrowing rate is set at a level that is above the US funds rate  to enable the country to compete for and attract funds to flow into the country. That depends on the premium that the country’s monetary authorities are willing to take.

These rates are calibrated well to the current anti-inflation policy. The average rate of inflation rate in 2021 was 4.5 percent.

All these numbers appear sustainable under current conditions, based on influences from the domestic economy and the broader regional economy.

However, they do not take into account the potential decisions that could happen in the US Fed. For the moment, it is not clear how it would set the the new funds rate. It could set this starting from 25 basis points or up to 100 basis points. What seems to be clear is that it will do this rate increase gently so as not to create a shock. What is important is to see what the interest rate will be by the end of 2022 or 2023.

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