US Fed interest rate move and the Phl economy

An external policy development that has the capacity to jar the trajectory of the Philippine economy comes from the US Federal Reserve Bank, the central bank of the largest economy in the world.

Janet Yellen signals rise of American interest rates and, hence, of world interest rates. In a recent speech, chair of the US Federal Reserve Bank Janet Yellen gave more definite signals that a rise in US interest rates will happen soon, perhaps this month.

In her public declarations, Yellen’ states the federal-funds rate will be raised once signs of growth and employment firm up.

No target rate of interest has been mentioned, but it is likely to be low initially. The Fed intends to boost the short-term rate at a gradual pace, in conjunction with the improvement of employment and the attainment of a two percent annual inflation rate.

It should be noted that in order to support the economy, the US Fed cut benchmark interest rates in December 2008 to near zero and has held it ever since to help stimulate the economy. It took a long period to get out of the recession and sustain economic growth.

The return of sustained economic growth rate of three percent and the achievement of nearly five percent unemployment – both considered very positive signs by US monetary makers – brought confidence t the US economy could now respond to more normal monetary policy incorporating higher interest rates.

Impact on the Philippine economy. The threat of a rise in interest rates from their present low rates in the US and the world unsettles the Philippine economy in several ways.

First: volatility of capital flows in the country. A rise in interest rates n the US – by whatever small margin – affects the portfolio capital invested across the world. Rising rates in the US attracts funds to go to the US at the expense of those invested in other countries.

The volatility of capital flows in the balance of payments of the country happens as changes in interest rates and investment opportunities in other markets compete for funds. Such fluctuations are not often in the general public consciousness, but they happen nevertheless.

In fact, few economic watchers really understand the direct impact on the volume of capital inflows or outflows. But such movements have an echo on the daily fluctuations observed in the Philippine stock market index. In recent years, the large fluctuations have been the knee-jerk reactions of stock market investors on these capital flows.

This explains to a large extent the extreme volatility of the Philippine stock market in the last three years, especially the last two, when rumours of changing policies at the Fed had become a trigger for sharp drops of the PSE index.

In April, the index peaked at 8,127. Hints of US Fed discussions of interest rate change have caused the index to fall drastically. After the announcement of the US Fed’s future move, the index fell to 6,800. It has hovered lately in the range of 7,800 and 6,800, with a tendency to move further downward.

Second: rise of investment costs. The rise of US interest rates affects global interest rates instantly. When government and private companies seek financing from the world’s capital markets, they face higher interest rates.

Moreover, as a domestic reaction, the Bangko Sentral could adopt defensive measures by raising rates too. Thus, local investors would pay higher rates of interests as well .

Third: effect on the peso exchange rate. The influence on the exchange rate is not likely to be direct. It is the size of the capital flows induced by the rise in interest rates that affects the exchange rate market.

Capital flight could occur if the interest rate hike in the US attracts investments to relocate from the Philippines. If capital outflows exceed inflows, peso depreciation would occur.

If the country remains attractive, however, forces that induce peso depreciation could be blunted. However, it is well to remind ourselves that many factors are responsible for the peso exchange rate to change, this factor being discussed is only one force.

In recent months, the peso exchange rate has crossed the line from P46 to P47 to the dollar. Despite efforts of the Bangko Sentral to support, this recent depreciation of the peso could push the exchange rate toward more loss of value in part as a reaction to the market volatility and nervousness related to the anticipated US Fed move.

For the moment, the impact on peso depreciation by the anticipated fractional change in interest rates might be small. That could move toward a larger range if the impact on capital flows encourages more outflows than inflows. So far, that has been the direction.

It is, however, important to say that the more important factor pertaining to the exchange rate is how well it relates to the overall protection of the balance of payments in general.

Recent depreciation of the peso has the beneficial impact of making the country’s export sector more competitive. Hence, exchange rate policy belongs more to the overall issue of international competitiveness of goods produced in the country.

Monetary policy helped restore US economic growth.

We take a look at how the US economy got out of the recession and restored growth.

Gridlock in US economic policy-arises in the area of fiscal policy. Congress and the president do not agree on policies. The result has been inaction in fiscal policy to combat the recession.

Ideally, anti-cyclical policy should best be dealt with policy tools that can have a direct bearing on aggregate expenditure. That is essentially the domain of government fiscal policy.

This branch of economic policy-making requires a good combination of public spending, taxation and debt policy. It is like a trio of musicians producing good chamber music.

However, during this critical period of lowered economic activity, it has been monetary policy that provided the required stimulus toward economic recovery. The independent central bank chose to keep interest rates to zero level. Furthermore, it bought large amounts of private debts through a policy of “quantitative easing.”

These measures provided prolonged and continuous stimulus until economic recovery took place.