Joseph Yam US Interest Rates

inSight

23 May 2002

Joseph Yam US Interest Rates

For Hong Kong the positive effects of a hike in US interest rates - whenever that might occur - are likely to outweigh the negative effects.

With the market anticipating, sooner or later, a hike in interest rates in the United States, it is natural for us to be asking what impact such a move would have on Hong Kong. It is, of course, clear that, given the fixed exchange rate between the Hong Kong dollar and the US dollar, we will need to follow suit in adjusting Hong Kong interest rates. What is not clear is the impact on the economy in terms of, for example, the unemployment rate, the GDP growth rate and the inflation (or deflation) rate. It is tempting for commentators to take the simplistic view that higher interest rates would hurt the economy. Other things being equal and with excess capacity in the economy, this may indeed be the case. But the economic reality is such that other things are not always equal and so we have to take into account, crucially in this case, the preconditions for a hike in interest rates in the United States, as we see them.

One important precondition is the perceived risk, as seen by the Federal Open Market Committee (FOMC) of the US Federal Reserve, of inflation. Looking from afar, I doubt if the risk, if any, is currently large enough to warrant immediate action on the interest rate front. But, depending on the strength of the economic recovery that currently seems to be on the way, there may be a need for pre-emptive action, which the FOMC has been rather skilful in taking in recent years. However, the important point to note here is the strength of the economic recovery. If it is robust enough to warrant a change in the monetary policy stance in the US, we should all have reasons to rejoice. The favourable effects, working through stronger external demand and higher world prices, on Hong Kong's exports should be good news. Indeed, Hong Kong's exports have recorded significant growth in the first quarter of this year and export orders received in the same quarter, according to admittedly anecdotal reports from exporters, have been the highest seen for some years.

Our Research Department in the HKMA has recently conducted an analysis of the likely impact on Hong Kong of an interest rate hike in the United States. I do not wish here to go into the technical details of the econometric model used (please visit the Research Memoranda page on the HKMA website for the full analysis). But the main message of this piece of research work is that the positive effect, in the form of an increase in external demand, will more than offset the negative effect of higher borrowing costs and possibly an appreciation of the nominal effective exchange rate. Using the assumption of higher growth in world output and therefore in external demand for Hong Kong's goods and services, the model suggests a higher output growth and a lower unemployment rate for Hong Kong, and some relief on deflation. We are fairly confident about the direction of change thrown up by the model but less so concerning the quantitative extent of change. Obviously there is room for improvement in this research work.

The results are in fact not surprising, at least not to us. For a small and highly externally oriented economy with no external debt servicing requirements like Hong Kong, output should be less sensitive to interest rates than external demand. So even when the two come along hand in hand, Hong Kong stands to benefit. But clearly different sectors of the community will be affected differently, as a result of both higher interest rates and higher external demand. The fixed salaried mortgagor, for example, may not stand to benefit immediately and will probably have to wait until the higher economic growth filters through to higher salaries for them. And meanwhile there may be higher monthly mortgage payments or an extension of the mortgage repayment period. But exporters will be able to feel the positive effect sooner.

 

Joseph Yam

23 May 2002

 

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