Puzzle of US Monetary Normalization Policy

With excessive global liquidity, the rise of interest rates in the US and the downsizing of the balance sheet of the Fed have greater potential to cause capital outflows from emerging economies. In the future, the US dollar exchange rate will tend to strengthen until the normalization process is completed in 2020.

KOMPAS/DIDIE SW

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The United States monetary normalization policy does not have great potential to cause a global financial crisis, especially due to capital outflows.

However, with excessive global liquidity, the rise of interest rates in the US and the downsizing of the balance sheet of the US Federal Reserve (Fed) have greater potential to cause capital outflows from emerging economies. In the future, the US dollar exchange rate will tend to strengthen until the normalization process is completed in 2020.

Monetary normalization is a policy that must be carried out by the US after extraordinary steps -- carried out by the US in particular and the G-20 in general -- to restore the economy after the global financial crisis and deep recession of 2008/2009. In addition to strong fiscal expansion, namely with a widening deficit of up to US$1.4 trillion (10.1 percent of gross domestic product) in 2009, the monetary policy was relaxed. This was reflected not only by lowering interest rates to near zero percent but also in non-conventional policies, commonly called quantitative easing (QE).

Risks and benefits

In November 2008, the Fed announced the purchase of debt securities, including in the form of mortgage-backed securities (MBS) of $800 billion. This policy was extended in March 2009 to June 2010. The November 2008-June 2010 period was often referred to as the first round of QE with a total purchase of debt securities of around $1.72 trillion, including around $300 billion in government bonds.

In November 2010, a second round (QE2) was carried out with the purchase of debt securities, especially government bonds, amounting to $600 billion. In September 2012, the third round of QE was conducted with purchases of $40 billion in the form of SBM and $45 billion in the form of debt securities. In January 2014, purchases were reduced to $75 billion per month -- marking the tapering period -- which was further reduced to only $35 billion per month in July 2014.

QE is a controversial policy that is not without risk. First, QE has the potential to increase inflation if the amount of QE is higher than what is needed. Too much money is created in the form of asset purchases. Second, QE can fail to promote aggregate demand if the financial sector is reluctant to disburse money to businesses and households. Third, QE weakened the US dollar. The strengthening of currencies against the US dollar triggered a currency war, which was introduced by the Brazilian finance minister, which had the potential to increase protectionism and devaluation.

Fourth, QE encouraged US capital outflows to be invested in emerging markets and commodities. Fifth, QE was feared to worsen the income gap in the US by encouraging the amount of shares owned by the rich. Sixth, QE worsened the Fed\'s financial balance sheet, creating the potential to cause bankruptcy. The Fed\'s balance sheet, which in 2007 was only around $920 billion or 6.6 percent of gross domestic product (GDP), jumped to $4.56 trillion in 2014 or 26.1 percent of GDP. Even though different from commercial banks, the possible bankruptcy of the Fed would be the responsibility of the US government.

Despite being controversial, QE, especially QE1, was considered capable of safeguarding the US economy against the possibility of a major depression in the US. QE1 also helped stopped liquidity scarcity after the collapse of the Lehman Brothers by pushing back capital flow to Asia. The next QE was more influential in strengthening the exchange rate of other currencies than the US dollar and property prices. QE2 and QE3 were seen as less effective in accelerating US economic recovery.

In line with US economic recovery, the monetary policy was directed at normalizing interest rates and returning to conventional policies. Signs of normalization in US monetary policy were seen in May 2013 and that QE would be stopped in mid-2014. The signs caused considerable fluctuations in capital flow, which in turn affected the exchange rate of currencies, and in stock exchanges especially in Asian emerging economies. The fall in the purchases of debt securities by the Fed since the beginning of 2014 marked the beginning of a turning point in US monetary policy.

With the improving US economy, especially the decrease in unemployment, the interest rate was gradually increased to 0.50 percent in December 2014 to 2 percent in June 2018.

Risk of normalizing US monetary policy

Normalization of US monetary policy is aimed at two things, namely to return interest rates to a normal level and to improve the Fed\'s balance sheet by reducing problematic assets. The puzzle lies in how high the US benchmark interest rate is raised and how the Fed improves its balance sheet, plus to what extent the Fed balance will be downsized, how the mechanism will be carried out and when the desired target is reached.

Under normal circumstances, an increase in US interest rates does not have the potential to greatly cause excessive capital flow reversal. Increases in the US interest rate will be done carefully and measurably so as not to interfere with the recovering US economy. Despite improvement, the US economy has not led to an overheating condition.

US economic growth in 2017 was 2.6 percent and in the second quarter of 2018 it was 2.8 percent (compared to the same period the previous year, or year on year, y-o-y) despite a quarterly growth of 4.1 percent (q-t-q, annualized). The US economy is expected to grow 2.8 percent in 2018 and slow to 2.4 percent in 2019. Inflation in June 2018 reached 2.9 percent, exceeding the normal rate, partly as a result of rising energy prices.

This situation was different from the US interest rate increase in 2004-2005. With US economic growth at around 3.8 percent in 2004 and inflation at 3 percent, the Fed funds rate (FFR) was progressively and measurably increased from 1.25 percent to 5.25 percent. In short, unless there is an impetus for economic growth resulting in economic warming (overheating), the FFR will gradually increase to 2.50 percent or a maximum of 3.25 percent. This is in line with the Fed\'s plan.

Meanwhile, in improving the balance sheet, the Fed has been quite careful in reducing problematic assets in its balance sheet. The sale of matured debt securities has been increased gradually, with a part of them again being used to buy debt securities.

With net sales rising from $30 billion to $50 billion per month, the Fed\'s balance sheet is expected to be reduced to less than $3 trillion, or around $2.5 trillion by the end of 2020. Therefore, the impact of a contraction in the US economy will not be too big. Furthermore, more than half of the economists in a Wall Street Journal poll believe that reducing the balance sheet will increase the yield on US debt securities only by 0.2 percent.

On paper, the impact of the Fed\'s normalization of interest rates and financial balance sheet is not expected to be large. However, the normalization plan will not be disrupted or delayed. As long as the US economy grows at a relatively high rate, the unemployment rate will be quite low (3.9 percent as of July 2018), while the risks faced by the US will remain large if the normalization policy is not implemented as planned.

However, prudence is still required. First, the amount of capital outside the US during QE implementation is quite large. The International Monetary Fund (IMF) estimates that between 2009 and 2013, portfolio investment in emerging economies increased cumulatively by $1.1 trillion or around 2 percent of GDP of the recipient countries. Second, an increase in US interest rates after passing certain thresholds could accelerate the flow of capital back to the US and at the same time increase returns on US government debt securities. Third, it is not impossible that US economic policy, which is uncertain and refers more to US interests, will further push capital flows from emerging economies more progressively.

Bambang Prijambodo, Expert Staff of the National Development Planning Minister