[Lee Jong-woo's Economic Reading] Signals of Monetary Tightening from BOK and Fed... Expectation of Money Movement Changes in Asset Markets

US Tapering Officially Discussed
South Korea's Economic Growth Forecast Revised Upward
Economic Recovery Stage for Interest Rate Hike
Extent of Low Interest Rate Side Effects Is Key
Recovery of Economic Self-Sustainability Also a Concern

Signals have emerged both domestically and internationally indicating a reduction in financial easing policies. In April, the U.S. Federal Open Market Committee (FOMC) discussed plans to reduce the amount of liquidity supplied through quantitative easing. Although the premise was "if economic recovery meets expectations," the mere official mention of tapering (asset purchase reduction) suggests that the timing for liquidity supply reduction is not far off.

The economic recovery that the U.S. Federal Reserve (Fed) considers a prerequisite refers to improvements in employment indicators. Although employment in the U.S. has steadily increased over the past year, there are still 8.2 million fewer jobs compared to pre-COVID-19 levels. Among the nearly 10 million unemployed, 35% are in long-term unemployment. Since the employment data in April was poor and did not meet the prerequisite, the Fed cannot reduce liquidity immediately. Even if nearly 1 million jobs are added in May, the situation remains similar. A similar employment trend must be maintained for at least three months before policy can change, which would be around September. In 2013, the Fed announced the start date six months before reducing liquidity supply. If the same approach is followed this time, the reduction in liquidity supply would begin in early Q2 next year. Although there is still about a year left, the mere discussion of tightening, which had been stalled, is enough to bring changes to the market.

The Bank of Korea is changing its policy direction somewhat faster. At the May Monetary Policy Committee meeting, it raised the economic growth forecasts for this year and next year to 4.0% and 3.0%, respectively. Regarding monetary policy normalization, it stated, "It should not be rushed, but the side effects of delay are also significant." According to the Bank of Korea, this means there is not much time left before interest rate hikes.

Both South Korea and the U.S. have economic conditions that exceed the criteria for raising interest rates, so the decision to raise rates will depend on the extent of side effects caused by low interest rates. The most commonly cited side effect of low interest rates is the rise in asset prices. Apartment prices in the Seoul area have risen for over 60 consecutive weeks. Last year, the nationwide real estate price increase exceeded 9%, and this year, prices have shown unstable behavior, rising with even slight triggers. The situation is no different in the U.S. Housing inventory, which was equivalent to three months of sales before COVID-19, has dropped to 1.4 months. Money is flooding into the real estate market due to low interest rates, rapidly depleting housing inventory. Demand is growing stronger in contrast to the shrinking inventory. The average housing sales period has shortened from 44 days pre-COVID-19 to 21 days, and 51% of homes are sold within two weeks of listing. If price increases were limited to one or two asset classes, it would not be problematic, but the rise spans real estate, bonds, stocks, and cryptocurrencies, causing concern.

In the 1970s and 1980s, central banks primarily focused on fighting inflation because high inflation was an obstacle to the economy. The two oil shocks in the 1970s and stagflation?where economic recession coincided with high inflation?were all caused by inflation. Since 2000, inflation has ceased to significantly impact the economy. Even when oil prices reached $150 per barrel in 2007, consumer price inflation rarely exceeded 4% in most countries, indicating price stability. Instead, asset prices caused problems. The U.S. experienced severe economic slowdowns in 2000 and 2008. The 2000 slowdown was due to the IT bubble burst, and the 2008 crisis was triggered by the collapse of the real estate bubble leading to a financial crisis. The focus of central banks shifted from inflation to asset prices.

Another side effect of delayed interest rate hikes is the weakening of the economy's self-sustaining power. Prolonged use of strong policies such as zero interest rates has altered the economic structure accordingly. In this situation, the economy becomes fragile and unable to withstand even minor changes, requiring continued strong policies to maintain stability. Europe exemplifies this case. After the U.S. financial crisis and subsequent fiscal crisis, its economic structure weakened, and despite lowering interest rates to negative levels, the economy has struggled to recover. Both South Korea and the U.S. have experienced significant side effects from low interest rates, prompting them to begin reducing financial easing policies.

At the beginning of this year, there was a rise in interest rates with tightening in mind. South Korea's 10-year bond yield rose to 2.2%, and U.S. rates increased from 0.8% to 1.7%. Although the stock market was shaken by the rise in interest rates, it quickly stabilized and is now higher than before the rate increase. The primary effect of the interest rate rise on the financial market has disappeared.

If the reduction of financial easing intensifies, a secondary effect may emerge. Money that had been concentrated unilaterally in risky assets such as stocks may partially shift to safer assets like bonds, weakening real estate and stock prices as a result. When South Korea's government bond yield exceeds 2.5%, A-rated corporate bonds yield 3.5%, and the lowest investment-grade BBB+ bonds yield in the mid-4% range. Korean Air falls into this rating category. Yields on subordinated bonds and hybrid capital securities issued by banks and financial institutions are also likely to rise to the mid-4% range. This increases the competitiveness of bond yields.

The KOSPI first surpassed 2000 in 2007. Currently, it is around 3200, representing a 60% increase over 14 years. If one had invested in A-rated corporate bonds during the same period, the returns from bonds would have been much higher than stocks. This is just considering simple interest income; if one also accounts for gains from bond price increases and investments in higher-yielding products like subordinated bonds, the return gap widens further.

Money moves toward the side with comparative advantage. Even if interest rates are high, if other risky assets offer returns that surpass interest rates, money flows there. Currently, the opposite is true. Even if some of the numerous easing policies are withdrawn, interest rates will remain low. The problem lies with risky assets, whose prices are so high that there is concern not only about returns but also about potential losses. In this state, even small fluctuations can cause money to move. The nature of funds will likely shift toward minimizing risk, and the policy changes by the Bank of Korea and the Fed may become a catalyst for changing money flows in asset markets.