Adam Ahmad Samdin
Inflation and the Global Rate Hike Cycle
This piece will look at where we are at in the current rate hike cycle both in the West and in Asia, drivers of inflation, why it has panned out as such in Asia, and implications for rate hikes moving forward.
Overview: 2023 – A Year of Moderation for Inflation, Growth, and Hikes
The Fed is already moderating its rate hike cycle, while the ECB still has some ways to go due to starting later. Both supply and demand factors have driven inflation, but US has faced strong demand-pull inflation in revenge spending, while the EU faced significant supply-side shocks due to energy prices and the Ukraine-Russia war. Both shocks, however, are moderating.
The aggressive path of the Fed in 2022 has led to monetary policy divergence in Asia, putting pressure on central banks to defend their currencies, leading to depleting reserves and in some cases, an import cover that is rather uncomfortable. With rates catching up and the Fed starting to slow, however, the pressure on Asian currencies are for the most part subsiding, and foreign exchange reserves are recovering as well.
The macro outlook for 2023 is a year of moderation. An anticipated soft landing in the US and the EU still means there is moderation in the global economy – not just in terms of inflation, but for growth as well. Slowing growth in the US and high debt risks in the EU are the key risks to rising rates. Overall, we are seeing weaker international demand, a softer manufacturing outlook, and currently, an electronics downcycle. While Asia is likely in for tough times ahead, we expect the continent to remain resilient and avoid a recession due to China’s reopening, tourism, and regional/domestic demand.
This has started to translate into rates we are already seeing a pause in Bank Indonesia and the Bank of Korea. The Bank of Korea might even slash rates at the end of 2023, or the start of 1Q24. Other Asian central banks are likely to pause soon as well, such as the Reserve Bank of India and Bank Negara Malaysia. Meanwhile, the BOJ and the PBOC are choosing to keep rates accommodative due to domestic conditions and objectives.
The Global Picture
As a slew of rate hikes was announced by various central banks in the last two weeks, different officials have made comments about the hike cycle and the state of the global economy. While the pace of inflation is peaking, price pressures are not completely subsiding either.
Drivers of Inflation in the West
With Germany’s provisional harmonised inflation data posting a 5-month low at +9.2% y/y (Dec 22: +9.6%), it is clearer that the surge of inflation has peaked in the West. Inflation data for the rest of the EU as well as the US have also shown a moderation in inflation charge, as prices begin to ease. Broadly, the West has faced significant price pressures – for different reasons.
High prices in the EU driven by cost
The EU faced rising cost pressures from higher natural gas prices in the past few years. In 2021, unexpectedly high demand in South America and Asia drove prices upwards in an initial spike, as well as a colder-than-usual winter. When Russia started to lower Nord stream capacities, before shutting off gas supplies indefinitely in 3Q22, inflation spiked higher in the Euro Area despite the region showing lower levels of economic activity.
Inflationary pressures have caused the ECB to hike their interest rates by a total of +300bps since 2Q16 from 0%, with the latest policy rate being 3.0% after Feb 23’s monetary policy meeting. The BOE also raised their interest rates for the 10th consecutive time to 4.0% in Feb 23 from the COVID-era low of 0.1%, as the UK struggles to fend off inflationary pressures not just after higher gas prices, but also from a Truss hangover.
In the US, Demand Fuelled the Inflation Charge
In the US, we have seen a resurgence of demand after the era of COVID-19. Pandemic-related stimulus checks gave private consumption a boost, while real wage growth kept animal spirits high despite the highest run of inflation in 50 years.
Tightness in the labour market throughout 2022 led to this higher wage growth, as a talent shortage caused firms bidding higher to attract and retain high-value employees. Even today, amidst downsizing and job shedding measures in tech and other professional services to cut costs, wages remain elevated as firms are choosing to pay premiums for talent – keeping real wage growth in the green. And when disposable income ran low, consumers have been choosing to draw on savings to continue the spate of revenge spending. And when savings ran out – consumers again chose to increase borrowings and debt.
Changing Global Narratives: Inflationary Pressures are Starting to Subside
However, high inflation and debt cannot last forever. Recent developments suggest that the global narrative is starting to change. The drivers of inflation in the West are slowing down, and there is reason to believe that previously looked-at data is no longer as significant for monetary policy decision-makers.
In the US, we are seeing real wage growth starting to peter out around an annual 6% every month. Wage growth was driven by a talent shortage in professional services, but there has been a reversal in high-income sectors like tech and finance. This has led to mass layoffs in both sectors, and the slashing of headcount vacancies. Reduced demand for employment means that real wage growth, which was partially driving private consumption and inflation, is slowing down.
Additionally, higher interest rates are also starting to bite. Personal savings rates in the US troughed in Sep 22, bouncing back from 2.4% to the most recent 3.4% print in Dec 22. While still below trend, it is still increasing, meaning consumers are reining in their spending. Loan growth has also peaked at +18.2% y/y in Oct 22, and has started to moderate to +16.8% y/y in Jan 23.
In the EU, an unusually warm winter was looked upon favourably as cost pressures from energy were not as painful as what was expected. Already, the peak in both natural gas prices and headline inflation seems to have passed in Figure 2.
Speeches and monetary policy documents in the last few weeks are also suggesting that globally, central banks are slowing down. Bank of Canada’s monetary policy statement outright stated that they expect to “pause hikes”, while the ECB’s Fabio Panetta warned against the propensity to “unconditionally pre-commit” to any policy direction.
Overall, the post-pandemic high is starting to subside, and global growth slowing down. Cost pressures are starting to subside as well, with not only energy prices easing, but supply chains also facing less pressure as PMI data reports lowered demand for inputs.
Where are Rates in the West Heading Next?
Despite some easing, this does not mean that March 2023 will see a pause.
The Fed is likely to peak first, but they will not pause anytime soon – let alone start deceasing rates. The recent CPI print for Jan 23 (Headline: +6.2%; Core: +5.6%) came in lower than Dec 22, but was still higher than expected. We expect the next meeting in Mar 23 to result in a further +25bps hike, while data in the next few months will guide decisions beyond 1Q23. While our baseline is for the rate hike path to take a pause after another +25bps in May 23 to bring the terminal rate to 5.0-5.25%, the key risk is inflation remaining stickier than expected, forcing the Fed to hike further after a pause.
The ECB meanwhile will likely see their rates peak later – because they started raising rates much later as well. Lagarde’s recent speeches however seem to suggest an even more hawkish tilt than before. The strength of labour unions is also resulting in elevated wages. We expect Mar 23 rates to be +50bps as Lagarde remains steadfast. While the future rate hike path will depend on more data, our baseline is to expect another two +25bps hikes in both May 23 and Jun 23 to bring the terminal rate to a peak of 3.5%. However, recent data suggests that the European economy is bouncing back better than anticipated, and we do not rule out a +50bps hike at May 23 either, which would bring 2023’s peak rate to 3.75% instead.
Overall, higher rates in 2Q23 are likely to mean that consumer spending will fall back even further, as higher deposit rates disincentivises further spending, and consumers try to pay back the higher levels of debt. As the price of new investments rise due to the higher price of loans, we expect it to continue to slow as well. Despite the anticipated slowdown, however, the American economy does have strong fundamentals going into 2023. Our baseline is for the US to very narrowly avoid a recession in 2023.
In the EU, the main risk in relation to interest rates are private debt defaults. Since the ECB started raising rates above 0% since Jul 22, the number of businesses facing bankruptcies has soared in comparison to pre-pandemic levels – while the number of new business registrations have flatlined. Spain in particular is most at risk by a wide margin, and Spanish businesses (along with the rest of the EU) are likely going to face higher insolvency rates. Key risks to Italy and Spain are also higher because of higher interest rates, due to the high exposure to variable-rate contracts both economies have in comparison to the rest of the EU.
The other prominent risk to look out for in the EU is public debt. On this, not only are public debt defaults a more likely scenario than before, but the spigots of fiscal policy are also tightening further as higher rates also mean public debt repayment face higher premiums, and future debt becomes more expensive. However, we think that most governments in Europe are likely to have a good foothold on the matter. Looking at the data, debt-to-GDP ratios across the bloc have been falling from pandemic highs even for the usual suspects, and are likely to continue to fall in 4Q22.
Slowing global will bring some relief for APAC central banks
With the Fed hiking aggressively in 2022, monetary policy divergence had led to significant outflows of money as investors could get higher returns in the US. This led to the greenback appreciating significantly in comparison to Asian currencies, which worsened import-inflation for the East and increased currency volatility. It was a struggle for central banks in the region as on one hand, they wanted rates to remain relatively accommodative, as Asian economies generally exited from the pandemic later and demand was weaker. However, on the other hand, falling too far behind would risk further currency devaluation and volatility.
To remain somewhat accommodative and fight against currency depreciation, APAC central banks defended their currencies through significant levels of currency intervention in 2022, which had depleted foreign currency reserves in holding until a trough in 3Q22. However, as rates started to catch up with the Fed in 2H22 and changes in the macro environment, currencies also started to stabilise. This gave monetary authorities some time to claw back some of the spent international reserves, to strengthen import covers once more.
In terms of intervention, Singapore, the most trade-weighted economy on the list, seemed to be the most affected, with a -32.3% dip in FX reserves when comparing Sep 22 holdings to the start of the year as the MAS sought to defend the $NEER while tightening 4 times in 2022. Singapore’s import cover (the number of months of imports that current levels of reserves can cover) also saw a significant decline from 11.9 to 7.1 months. Despite facing the sharpest dip, it is still a relatively healthy buffer – albeit significantly leaner than before.
Vietnam was the next most affected, with their foreign exchange reserves declining by 21.7% by Sep 22 from Jan 22. However, unlike other economies, their reserves continued to shrink until the latest dataprint of Nov 22 – while other economies generally improved. Vietnam’s import cover has historically been around the 3-4 month mark, but with reserve depreciation, it has fallen to 2.8 – which is not just below the rest of her Asian peers, but also below the IMF recommendation of 3 months.
Japan’s position with regards to foreign exchange reserves is marginally better in Jan 23 compared to Sep 22, however the BOJ’s decision to keep rates unchanged is likely a reason behind continued outflows. Import-cover-wise, Japan still has a generous buffer compared to her peers – a necessary protection measure given their almost 100% import dependence on oil.
The majority of the Asian/ASEAN economies on the list have already managed to replenish some of their reserves. However, with the Fed starting to slow down rate hikes, monetary policy divergence is starting to slow as well. This will bring more relief to Asian central banks.
So what does the rate hike cycle look like for Asia?
The rate hike cycle in APAC has been a fair bit different compared to the West. While the region was also subjected to inflationary pressures, other considerations play a part as well
Economies like Indonesia and Malaysia heavily subsidise essentials like food and energy. This means that consumers don’t face the brunt of higher commodity prices, but it has weighed down significantly on government budgets. Fiscal consolidation is also a key issue in emerging Asia for 2023.
The demand picture was also different. Unlike the West, some Asian economies like Taiwan, South Korea, and Singapore rely more heavily on exports instead of domestic consumption. With demand from the US, EU, and China moderating, demand-pull inflation was not felt as strongly.
Asian economies generally exited the COVID era significantly slower than both the US and the EU. This means that demand did not revive as quickly as well. South Korea was the first Asian economy to ease restrictions, and is probably the only Asian economy to be in lockstep with US rates.
Generally, idiosyncratic factors such as a slower exit from the pandemic, subsidies, and being more export-oriented rather than domestically inclined makes for a different inflation picture, and hence, a different rate hike path.
Asian rates will march onward at diverging speeds
Indonesia’s BI and South Korea’s BOK have both already signalled a pause in the recent Feb 23 monetary policy meetings. Perry Warjiyo has signalled that 5.75% is enough for now, while Rhee Chang-yong’s board were open to another +25bps to bring the rate to 3.75% in the future if necessary but has stated that a more “delicate” response is necessary. Despite the hawkish tilt, it is noteworthy that the year-long run of rate hikes at the BOK has paused
Malaysia’s BNM has also held rates firm in the most recent meeting after a series of 4 consecutive +25bps hikes. However, we expect BNM to deliver a final +25bps either in their next meeting in Mar 23, or in May 23 before the end of 2Q23. Manufacturing in ASEAN is expected to remain weak across the board, although there are some pockets of resilience to help avoid a full-on recession in 2023.
India’s RBI recently delivered a +25bps hike in Feb 23’s meeting, and in total, they have already raised rates by +250bps since May 22 to tackle inflation. While higher-than-expected inflation in Jan 23 and the recent monetary policy committee stance points to the RBI delivering another +25bps hike in Apr 22, more data released in Mar 23 will be what guides the decision and we do not rule out a pause, either. Overall, levers of growth are expected to moderate; exports are expected to fall due to weak international demand, private CAPEX is expected to moderate, and the recent budget is more prudent as the targeted deficit, -5.9% of GDP, is lower than FY23’s -6.4%.
The SBV meanwhile has been keeping their discount rate firm at 4.5% after two back-to-back +100bps hikes in Sep 22 and Oct 22. While we would typically expect further hikes due to inflation, not to mention a steadily decreasing import cover below comfortable levels, we note that the VNIBOR has been materially above benchmark rates since early 2H22 - with the VNIBOR now being as high as 9.4%. Since there has been upwards pressure on policy rates for some time now, it is likely the resistance to further hikes by the SBV is intentional. This makes it less certain when or even if the SBV would raise rates in the coming months – given the recession risk in 2023. But, given rising inflation and the persistently high VNIBOR (albeit marginally declining for the past 2 months), as well as the low import cover, we expect rates to rise by at least another +50bps by the end of 1H23.
The BOJ is keeping rates steady at the -0.1% mark, as the central bank is using this opportunity to fight against Japan’s recent disinflationary pressures. While headline inflation in Japan seems to be high by historical standards, the BOJ has been standing firm to drive up wage growth – which does seem to be somewhat working. While we don’t expect any significant moves in Mar 23, we are expecting Ueda’s appointment to gradually move the BOJ towards normalisation at 0% by the end of 2023 given his previous talking points. Other board members like Tamura have also been more vocal in recent months about reviewing the BOJ’s ultra-loose monetary policy.
Singapore’s MAS is also facing inflationary pressures. While headline inflation stayed pat at +6.5% y/y in Dec 22, the recent print of Jan 23 saw a marginal rise to +6.6% y/y, like what we had originally expected in our Macro Note due to GST-related price movements. However, the 14-year high core inflation statistic of +5.5% y/y is even more notable. We note that the MAS has already tightened 5 consecutive times, with an unprecedented 2 off-cycle meetings in 2022. It is too early to be certain about what the MAS will do at their next meeting as well. However, if core inflation remains stubborn in 1Q23, we expect them to recentre the band of the $NEER again in Apr 23. But for now, it is more likely than not that the economy will start to moderate.
The PBOC also faces some difficult decisions up ahead. With private consumption remaining fragile, a weak property sector, and reduced exports due to a slowing global economy, it is likely the PBOC will cut rates by another -10bps by the end of Apr 23.
The rate hike path for APAC is rather diverse. What is certain however is that a pause is coming as well for Asia for most economies, and central banks will start to worry more about low growth rather than high prices by 2H23.
2023: A Year of Moderation, but Asia to remain resilient despite tough times ahead
Overall, we expect a soft landing in the US and the EU as demand weakens in the global economy.
This has already started to pass through to Asia. Currently, the tech downcycle has resulted in poorer performance in electronic product exports, which has significantly dragged economies like Singapore, Taiwan, and South Korea. Overall, since Asia and ASEAN is part of the supply chain for end-consumers in the US and the EU, the region is already experiencing less international demand. We expect manufacturing to remain weak across Asia as well, and US-China tensions with regards to chip decoupling can have various implications due to the linked nature of supply chains
While the region faces tough times ahead, we expect Asia to remain resilient and avoid a recession. Bright spots like China’s reopening to facilitate growth and tourism in Asia, healthier domestic demand and private consumption, and portfolio diversification from China away from the US into the continent will support economic activity
As the world worries more about slowing growth rather than high inflation, we will see rates peaking from 2Q22 onwards depending on domestic conditions. While the Fed worries about growth as demand continues to slow in the US, the ECB has added pressures from insolvency issues, public debt, and rising bankruptcies. In Asia, meanwhile, due to lower demand, some central banks are already signalling a pause in their rate hikes – and if not, a moderation
Finally, we have already seen Asian currencies strengthening. While most Asian economies will see foreign exchange reserves replenishing, some standouts remain – mostly those behind on the rate hike path, or those that focus on the exchange rate for monetary policy.
Adam Ahmad Samdin is the Head of Research at the SMU Economics Intelligence Club (SEIC), and a penultimate Politics, Law, and Economics undergraduate.
The views expressed are the authors’ own and do not represent the official position of the SMU Economics Intelligence Club. This article may not be reproduced without prior permission from SEIC and due credit to the author(s) and SEIC.