[Insight & Opinion] Rate Hikes Ultimately Lead to Slower Growth

Liquidity Masks Economic Reality
U.S. Economy Will Ultimately Freeze Up

[Asia Economy] The world is currently battling inflation. The U.S. central bank has stated it will continue raising interest rates until inflation falls to the 2% range, even if the economy worsens. An interesting point is the White House’s stance. President Joe Biden says that curbing inflation is the top priority of economic policy. In the U.S., gasoline prices heavily influence public support for the government. It is only natural to want to control prices. But to what extent? To control inflation, demand must inevitably be reduced, which cools the economy. The question is the degree of that cooling. Former U.S. Treasury Secretary Larry Summers argued that the country must endure an average unemployment rate above 5% over the next five years. Even if the economy deteriorates to that extent, would the White House still support the Federal Reserve’s rate hikes? That seems unlikely. The White House’s support for the Fed’s rate increases likely stems from a quiet belief that the U.S. economy is still holding up well.

The U.S. labor market remains strong. In August, the U.S. unemployment rate was 3.7%, maintaining the lowest level in the past 50 years. Consumption, which accounts for 70% of U.S. GDP, has not decreased. Retail sales growth in August rose 0.3% month-over-month, exceeding market expectations. This is truly unusual. The current situation contradicts textbook economics. When prices surge and interest rates rise, consumer sentiment typically worsens and unemployment rises. The low unemployment rate in the U.S. fuels stock market anxiety. If unemployment rises, the central bank might hesitate to raise rates, but at the current level, there is no reason to worry. The same strange phenomenon is happening in South Korea. In August, the number of unemployed was only 615,000?the lowest since monthly unemployment statistics began in June 1999. The August unemployment rate was 2.1%, the lowest in 23 years. This is essentially full employment.

What is causing this? There are several suspected reasons in both the U.S. and South Korea. First, there may be a labor shortage due to a declining working-age population. Some believe productivity has not increased as much as expected. This could be a reason to maintain employment. South Korea is also undergoing structural reorganization toward service industries that rely heavily on labor input. The biggest reason, however, is the lingering effect of the massive liquidity injected during the COVID-19 pandemic. Since COVID-19, the U.S. has pumped out a staggering $5 trillion. In South Korea, as of July, the broad money supply (M2) exceeded 3,700 trillion won, 700 trillion won more than two years ago. While one side is ringing the alarm bell, the party continues on the other. The Biden administration insists that increasing fiscal spending under the Inflation Reduction Act (IRA), including subsidies for electric vehicles, is a measure against inflation. South Korea is similar: while interest rates are rising on one side, an additional supplementary budget of 62 trillion won has been prepared on the other.

However, rapid interest rate hikes ultimately reduce growth. Policies take time to show effects. Unemployment is also a lagging economic indicator. In the U.S., job postings have decreased across nearly all sectors. The 3.7% unemployment rate in August actually worsened by 0.2% compared to July. The number of unemployed increased by 344,000. Employment declines inevitably lead, with a time lag, to falling asset prices such as stocks and reduced consumption. The international credit rating agency Fitch forecasts South Korea’s growth rate at 1.9% next year. In the past decade, growth fell below 2% only in 2020. The alarm bell has already rung, and the party will eventually end.

Kim Sang-cheol, Economic Commentator