[Lee Jong-woo's Economic Reading] Imminent Fed Rate Hike... South Korea May Raise to 2% by Year-End

US Interest Rate Hikes Likely to Accelerate
1% Rate Expected by Year-End
High Possibility of 'N'-Shaped 10-Year US Treasury Yield
Bank of Korea Also Joins Rate Hikes

In December last year, the U.S. Federal Open Market Committee (FOMC) announced plans to halt liquidity supply. The plan to reduce liquidity supply by $15 billion each month and complete tapering (asset purchase reduction) by June this year was accelerated to finish tapering by March.

As tapering speeds up, the possibility of interest rate hikes occurring sooner than expected has increased. At the same meeting in September last year, the Federal Reserve (Fed) stated it would raise interest rates once this year, three times next year, and three times the year after. At the December meeting, this changed to three times, three times, and twice respectively. According to this, the U.S. benchmark interest rate will reach 1% by the end of this year. Next year, it is expected to approach 2%, indicating that the monetary policy direction is rapidly shifting from caution to normalization.

The key factor prompting this policy shift is inflation. In November last year, the U.S. Personal Consumption Expenditures (PCE) price index rose by 5.7%, the highest in 39 years. For the Fed, this means it must use all means necessary to control inflation. Not only did the expectation that inflation would be temporary fail, but the increase was larger than anticipated, and if left unchecked, it could cause economic problems.

The problem is that stabilizing prices quickly is difficult. Currently, the U.S. inventory-to-retail sales ratio is about 1.1 times. This means that if no additional inventory is accumulated, all inventory will be depleted in 1.1 months. When inventory is insufficient, product prices rise, stimulating inflation. If household consumption capacity were weak, inflation might not worsen, but currently, U.S. household consumption capacity is at its highest level. Due to continued government support since the outbreak of COVID-19, the U.S. household savings rate rose to 9.4%. This is higher than the average savings rate of 7.2% from 2012 until before the pandemic, indicating that households have money available to spend whenever necessary.

The nearly 20% annual increase in U.S. housing prices also contributes to raising interest rates. Rising U.S. housing prices exert significant pressure on inflation because housing costs account for 33% of consumer prices. The real estate bubble that caused the financial crisis 13 years ago also made the U.S. government act urgently. Various measures to expand supply are being introduced, including policies adjusting interest rates and liquidity. Liquidity supplied to prevent economic slowdown after the COVID-19 outbreak played a role in driving up housing prices. If this is not corrected, it will be difficult to curb housing price increases, so the Fed is expected to accelerate interest rate hikes.

Labor shortages are another area to watch. As economic activities resumed, demand for service-related workers increased, but the inability to fill these positions led to rising labor costs. Currently, the U.S. is experiencing labor shortages across high-, middle-, and low-wage sectors. The fourth industrial revolution triggered by COVID-19 has sharply increased demand for skilled workers, but supply has not kept pace, causing wages to rise rapidly. Although the situation differs somewhat in low-wage sectors, the reduction in people willing to participate in the workforce causes wage distortions similarly. Since June last year, the number of job openings in the U.S. has exceeded 10 million. Besides voluntary unemployment for better jobs, it is difficult to find idle labor, making it hard to avoid inflation driven by high wages for the time being.

The possibility of U.S. interest rate hikes is already reflected in market interest rates. The yield on the 2-year U.S. Treasury note, a short-term rate, has surpassed 0.75%. This is nearly a fourfold increase from 0.2% in September, just three months ago, driven by expectations that rate hikes are imminent, pushing short-term rates higher. This rise is much faster than in the past. A similar situation occurred in 2015, but then short-term rates rose only 1.6 times over two years from the start of tapering to the first rate hike. Now, early in tapering, rates have already quadrupled. This reflects market expectations of rapid and strong rate hikes.

What impact will Fed rate hikes have on market interest rates? First, the 10-year U.S. Treasury yield is likely to follow an 'N'-shaped pattern similar to last year. It is expected to rise to the previous high of 1.8% in the first quarter when tapering ends and rate hikes begin, then retreat before surpassing 2% by year-end. The first-quarter rate increase will be driven by the possibility of benchmark rate hikes and inflation. Since tapering ends in March, rate hikes will be within sight in the first quarter. Inflation is also significant, so market rates will easily exceed previous highs.

After this phase, when the first rate hike occurs, a temporary retreat in rates is expected because the news becomes reality. This pattern has been observed every time the Fed raised rates in the past. Rates rose out of fear before the first hike, then fell after the hike, and this time will likely be no exception. After the decline ends, U.S. rates are expected to continue rising for a considerable period. This effectively marks the end of the low-interest-rate era, with the possibility of benchmark rates reaching the 2% range by the end of 2023 being fully reflected in market rates. Although this may vary slightly depending on economic conditions and Fed policy stance, the overall direction of rates will inevitably be upward. Many asset markets, including the stock market, will come under the influence of rate hikes starting then.

Central bank rate hikes will not be an exception for us either. The Bank of Korea is also likely to continue raising rates in 2022. If rates are raised once more in the first quarter, our policy rate will reach 1.25%. There is also a possibility it will rise to 2% by the end of the year, which will push market interest rates higher.

The timing of domestic rate increases will vary significantly. Most rate hikes are expected in the first half of the year, with increases being restrained in the second half. Economic slowdown and adjustments in the pace of benchmark rate hikes will likely prevent further rate rises in the latter half.

The decline in potential growth rate also helps prevent long-term rates from rising continuously. For a long time, the potential growth rate has served as an upper bound for long-term government bond yields. Since our potential growth rate is estimated to be in the low 2% range, long-term rates already exceeded this in the third quarter of last year. When the upper bound is clear, rates cannot continue to rise indefinitely.