ADB economists Matteo Lanzafame, Yuho Myoda, Irfan Qureshi and Arief Ramayandi answer questions about the impact on Asia of rising interest rates, based on their research for the Asian Development Outlook 2022 Update.
Rising interest rates by the United States Federal Reserve and other central banks around the world could have a significant impact on Asia. Policymakers in the region will need to carefully navigate the situation with the right policy mix for their economies, with a particular focus on helping the poor and vulnerable.
Central banks raise interest rates to curb accelerating inflation and safeguard price stability. The higher interest rate set by the central bank pushes up the lower limit for lending rates to firms and households, disincentivizing their consumption and investment. In turn, this reduces aggregate demand in the economy, thus lowering inflationary pressures. The policy rate set by the central bank thus acts as a fulcrum for the other interest rates.
Most recently, the United States Federal Reserve, often called the Fed, and other central banks started raising interest rates in response to soaring domestic inflation. In the US, low interest rates and increased government spending in response to the pandemic resulted in a sharp demand recovery and a tightening labor market last year, compounding the inflationary effects of supply chain disruptions. Russia’s invasion of Ukraine further increased inflation by raising energy and food prices.
The Fed hiked interest rates in July 2022 for the fourth consecutive time. This is its most aggressive hiking cycle since 1981, which has already pushed borrowing costs to the highest level since 2019. Inflation eased slightly in July but the decline seems not compelling enough for the Fed to loosen its reins. Indeed, Chairman Jerome Powell has since pushed back against the idea that the Fed may soon pivot toward a less aggressive policy. As such, the federal funds rate is expected to continue rising, especially with recently released core inflation numbers. Similarly, the European Central Bank also raised interest rates in July and September.
Rising interest rates shrink global liquidity, which may slow Asia’s recovery in several ways. For businesses, a tighter credit environment results in higher borrowing costs, reducing their profitability and investment incentives. As borrowing costs rise, households are also less inclined to spend, especially on durable goods and houses. Softening demand and weaker global growth pose challenges for Asian manufacturing and exports.
Monetary tightening in the US has led to investors pulling their money out of Asian economies, triggering currency depreciation in most of the economies. Sharp currency depreciation generally increases inflationary pressures through higher import prices of food and energy, worsens the current account balance, and may thus result in countries having difficulty with paying for their essential imports or servicing external debts. Policymakers in the region must remain cautious and vigilant, particularly where high, or fast-increasing debt burdens are amplifying economic and financial vulnerabilities. Economies with higher dependency on external creditors in dollar-denominated debt are already experiencing rising servicing costs and cash shortfalls.
Policy responses to Fed tightening by Asian central banks will depend on prospects for domestic inflation, growth, and financial stability. While price pressures in Asia’s developing economies remain lower than global averages, headline and core inflation are rising. In addition, the reopening of economic activities, stronger domestic demand, and falling unemployment are lending support to a firmer recovery. Many central banks in the region have already raised policy rates in response to these events, but it is likely that more tightening will be needed so as not to fall behind the curve. For now, real interest rates are low or even negative in much of the region, despite rising inflation expectations.
Going forward, central banks facing persistent pressures of currency depreciation may opt for a more aggressive hiking cycle, as well as the careful implementation of appropriate capital flow management policies to deal with potentially destabilizing and unwanted capital outflows. Policymakers will need to carefully navigate the current environment through the right policy mix for their economies.
Periods of tightening US monetary policy are generally associated with higher financial volatility, capital outflows, and currency depreciation in emerging economies. This is especially the case when tightening is sharper than expected, as it was in June. Concurrently, many central banks in the region started raising rates to combat rising inflation, stem capital outflows and smooth exchange rate fluctuations—but this may slow economic recovery.
This shows that higher inflation associated with increases in commodity prices poses complex challenges to monetary policymakers, forcing them to wrestle with the two conflicting objectives of price stability and higher growth. Given the largely incomplete economic recovery from the COVID-19 crisis, these challenges are currently acute in most of Asia’s developing economies. Central banks in the region should remain vigilant and act promptly to forestall persistent rises in inflation, which could not only jeopardize the objective of price stability but, ultimately, also slow down the recovery.
Rising interest rates hurt the poor the most. If central banks in the region hike rates in response to monetary policy tightening in the US, domestic liquidity will be squeezed, and growth will slow. On the other hand, rapid increases in the US interest rates may lead to capital flow reversals, currency depreciations, and possibly an inflationary spike that would likewise damage growth prospects. Either way, general economic conditions will get worse—and, unfortunately, when that happens, people in poverty bear the brunt.
When growth slows, layoffs increase, and formal and informal employment opportunities decline. The poor suffer more from losing their jobs—due to lack of social protection, difficulties in finding new employment as they are typically unskilled, and low income. Higher inflation would also impact them disproportionally by reducing their limited purchasing power. In summary, the poor will tend to suffer more than most as job prospects deteriorate and the cost-of-living increases.
In the short-term, this calls for rapid and appropriate policy actions to help people in poverty weather the storm if a crisis does materialize. On a longer horizon, it highlights the importance of strengthening social security systems and extending them to provide a minimum level of protection for all.
Developing countries in Asia will not be immune to spillovers from monetary tightening in the US and other major economies, but the region is well-placed to weather the consequences. Over the past few decades, and especially since the Asian Financial Crisis, most regional economies have adopted prudent macroeconomic policies, including flexible exchange rates to deal with external shocks, active monetary policy to contain inflation, and measured fiscal policy to keep public debts within reasonable and sustainable levels. These measures, along with continuing efforts to strengthen the social security system, will be critical in the months and years ahead.
This blog post was based on research contained in the Asian Development Outlook 2022 Update: Entrepreneurship in the Digital Age