US interest rates

inSight

13 May 2004

US interest rates

Hong Kong is in a position to cope well with the expected rise in US interest rates.

Financial markets around the globe seem to have been in a rather nervous mood lately. There are two issues of particular concern - the timing and the extent of the upturn in the interest rate cycle in the United States, and the prospects of the necessary macroeconomic adjustments in the Mainland of China being successful. There are other issues too - the surge in oil prices, ongoing geopolitical tension, continuing external payment imbalances, the threats of terrorism, impending major elections and so on. It is an uncertain world and uncertainty affects market sentiment.

Insofar as US interest rates are concerned, apart from the obvious question about the possibility of inflation resurgence in the US, there is the additional question of the attitude of the Federal Reserve towards the need for returning interest rates to a "normal" level. So everybody is looking closely at the unending stream of economic data, and taking anticipatory and consequential market positions accordingly. It is interesting to observe that robust economic numbers, such as those released recently on growth and employment, are now greeted by financial markets with more disappointment than encouragement. I find this a little surprising because US financial markets are so liquid and deep, and so richly served by analysts, that their efficiency in pricing prospects and risks should be beyond doubt. So my surprise must surely be a reflection of my inability from afar to appreciate the significance of the full spectrum of forces at play.

One of these may be the level of indebtedness of households in the US. The very low level of interest rates in the recent past has probably encouraged consumption and home purchase in the US to the extent of making the household sector more vulnerable to interest rate hikes. With a near zero savings rate, private consumption expenditure and residential house prices may be quite sensitive to interest rate changes. Thus historically housing prices and housing starts in the US bear a generally negative relationship to interest rates. Interestingly, this is not the case in Hong Kong. We have the exact opposite. Here, property market booms have in the past been associated, or at least coincided, with rising interest rates, and it will be interesting to observe whether this peculiar statistical relationship will again be borne out this time round. In any case, with low household indebtedness and a much higher savings rate, the household sector of Hong Kong is probably much less vulnerable to interest rate hikes. With interest income of HK$1.9 trillion of Hong Kong dollar deposits climbing out from near zero and expectations of favourable movements in property prices, the theoretical restraining effect of rising interest rates on household spending and housing investments, if any, may be quite mild.

Another uncertainty that has affected market sentiment in the US is probably the significance of interest rates returning to normal, if this is indeed the intention of the Federal Reserve, which is itself not clear. The fact is that the Fed funds rate has traditionally been 2% to 2.5% above the US inflation rate. With an inflation rate of around 1.5%, this implies a normal Fed funds rate of 3.5% or so. But rising commodity prices and a strong economy, notwithstanding the continued existence of a fairly large output gap, could mean inflation creeping to 2% or beyond, with implications for the Fed funds rate, if indeed the "normal" interest rate theory holds water. On this latter point, market commentary points to a delicate situation that needs careful balancing of pros and cons. On the one hand, there may be a desire to recoup room for monetary policy in case the economy disappoints and again requires stimulus. On the other hand, larger than expected increases in interest rates can be destabilising to financial markets, to the extent of leading to financial mishaps. The low interest rate environment of the recent past must have encouraged greater than usual leveraging. The bond market is obviously vulnerable to monetary tightening, as the experience of 1994 showed.

Here, again, Hong Kong is well positioned to cope. The household sector, as I mentioned earlier, is not particularly vulnerable. The corporate sector, also with low level of indebtedness (and probably rich with external assets), should likewise be generally resilient. The financial system is robust. In any case, the profitability of the banks is probably neutral to interest rate levels, all matters considered, including the recovering economy. And I hope that my alert at the beginning of the year, well before the current sharp market focus on all this developed, to the possibility of interest rate increases being "larger and sooner than expected" has helped in risk management by all concerned. So, even if this alert is borne out by actual events, we should be able to ride this one comfortably. Meanwhile, with a relatively small, global and nervous market that is influenced also by factors other than the interest rate outlook, we shall probably continue to see short-term gyrations in financial markets. But the underlying robustness of the economic recovery, and of the structure of our monetary and financial systems, should not be ignored.

 

Joseph Yam

13 May 2004

 

 

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