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The Fed Is Fighting the Last War on Inflation

The Fed Is Fighting the Last War on Inflation

Monday, 31 August, 2020 - 07:30

By signaling a more relaxed view of inflation and foreshadowing US interest rates will stay lower for longer, the Federal Reserve has given Asia’s economic chiefs a green light to rev commerce well into the coming decade. This offers the region a shot at healing some of the deepest scars of Covid-19. The risk of running things hot may not be felt for years, if then.

The rethink gives Bank Indonesia, which is underwriting government budgets, some space to keep experimenting. For the Philippines, where debt monetization has been subtler, there is an opportunity to be more overt. South Korea, which hemmed and hawed about undertaking a form of quantitative easing, can also be more definitive. In India, policy makers can set aside their fears of stubbornly high inflation and make further reductions in rates.

The influence of the dollar gives the Fed’s shift great consequence in this region. In theory, if the central bank is cool with inflation being above 2% for a while, we could be headed for a long stretch of dollar weakness. That means Asian economies, many of which have soft pegs to the greenback, are free to maintain easier policies without being penalized much by investors wary of weakening currencies. Morgan Stanley said the Fed’s new approach is “a key USD headwind over time.”

It’s when we get beyond the pandemic that the biggest impact of the Fed’s review — one with potential to supercharge the recovery — will be tested.

The overhaul was conceived in 2018, in the world before the pandemic, and is shaped by the terrain that emerged after the global financial crisis. That landscape was characterized by a sluggish recovery and very low inflation.

What could go wrong now? The Fed is fighting the last war, and the updated framework implies prices will behave as they did after 2008. The mistake in the aftermath of that calamity was to anticipate inflation pickups that weren’t forthcoming. But one key difference between then and now is the velocity with which central banks responded to this crisis and the full force of fiscal policy. Inflation could very well misbehave this time around.

And tumult doesn’t have to originate in the US. One of the most destabilizing periods for Asia in the past decade was China’s botched effort to devalue its currency in 2015. Another risk is if authorities overreach or become too confident in their ability to push the envelope. Indonesia hasn’t been cast into the darkness for debt monetization as it might have in a previous era. But lunch isn’t entirely free, either. After a stellar second quarter, the rupiah is Asia’s worst performer against the buck since July 1.

But the benefits to Asia of the updated Fed framework outweigh the potential costs. Right now an inflation spike would be a good problem to have. Even allowing for decent bounces in growth later this year and next, it's likely to be a long time before anything resembling normal price increases reappear. While labor markets in many economies are probably past their nadir, unemployment will decline only gradually from here. Entire industries, such as aviation, tourism and hospitality will take years to get over Covid-19 — and maybe not even then. Deflation is still the biggest threat, as I wrote here.

When the Fed began to back away from rate hikes in early 2019, I wrote that Powell had given Asia a gift. His latest present comes with a long battery life. All the region needs to do is plug it in.


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