End of austerity? Continuation? Unknown US economy…Moody’s, Xi Jinping, Trump [Hwa Sik Yong Hong].

The atmosphere has changed in just a week. At the end of October, the U.S. Treasury Department announced plans for a treasury issuance that fell below expectations, and the Federal Open Market Committee (FOMC) of the Federal Reserve (Fed) froze interest rates at the beginning of this month, raising expectations for a halt in tightening. However, on November 9 (local time), Chairman Jerome Powell reignited the spark for additional tightening.

On the 10th, Moody’s downgraded the outlook for the U.S. government’s credit rating to negative. A downgrade in rating outlook is a warning of a rating downgrade. The reason is that the cost of raising government bonds is increasing, and the likelihood of reducing the fiscal deficit is low. Moody’s is the only one of the three major international credit rating agencies still giving the U.S. an AAA rating.

However, the market atmosphere can change again in less than a week. This is because the U.S. and Chinese presidents are set to meet at the Asia-Pacific Economic Cooperation (APEC) summit next week. To fully understand the weight of this U.S.-China summit, it is necessary to properly grasp the essence of the global inflation crisis that hit in 2022.

▶Central bank tightening doesn’t work for all inflations

The most important task of a central bank is price stability. It is only natural that the central bank, which issues currency, prioritizes the stability of the currency value. But how much can interest rates control prices? The market economy is the interaction of two axes: demand and supply. It’s difficult to understand the market properly by looking at just one side.

There are two main paths to price increases: either supply decreases or demand increases. The prescription is to increase supply or shrink demand. The central bank’s interest rate hike works on the latter. By raising the cost of spending money, the cost of goods increases, reducing consumption. There is a side effect of increasing the burden of economic activity and causing a recession.

What is the prescription for inflation caused by supply shortages? It is to ensure that supply is stable and sufficient. Supply shortages can be divided into two types: when production is insufficient and when distribution is not smooth. If production is insufficient, it is possible to encourage investment. If interest rates are lowered, demand will also increase, so it is better to support it with fiscal policy.

The real problem is when distribution is not smooth. Structural improvements are needed, but today’s supply chains span multiple countries. It requires adjusting national interests. Not only for economic reasons, but also for security. The more diverse the interests, the more exponentially the variables for adjustment increase. This is why supply chain conflicts can lead to war.

The causes of current global inflation are twofold. On the demand side, it is the astronomical amount of money that was released to overcome the global financial crisis and the COVID-19 pandemic. On the supply side, it is the changes in the supply chain due to U.S.-China conflict and the war between Russia and Ukraine. The former can be solved by raising interest rates, but the latter cannot.

The global response was first to raise interest rates. Since they couldn’t immediately address the supply issue, they decided to approach it by reducing demand, even if it meant a recession, to control prices. But an odd phenomenon appeared in the U.S. Even when interest rates were raised, demand did not decrease. The U.S. government has invested a significant amount of fiscal resources to boost the supply chain, claiming that production is a matter of national security.

▶Thanks to the dollar… U.S., tightening + fiscal expansion = economic boom

When the U.S. raises interest rates, the dollar strengthens. This is a factor that lowers import prices. On the other hand, other countries also raised interest rates, but they could not fully enjoy the effect of lowering import prices because the U.S. also raised them. The U.S. has also spent much more money than other major countries on quantitative easing and overcoming COVID-19. The accumulated consumption capacity is also the largest.

The U.S. has the highest proportion of fixed-rate loans in household loans. Companies mainly borrow money through corporate bonds, and the maturity of these bonds is the longest among major countries. The effect of rising interest rates is gradually reflected in the real economy. As global investment funds head to the U.S. stock market, stock prices have risen significantly, and the value of assets of Americans, who have a high proportion of stocks, has also increased.

At a glance, it seems that the current problem in the U.S. is not inflation itself but the overheating of the economy. The Fed is alleviating price increases due to supply shortages with a strong dollar, and the government is supporting supply enhancement through fiscal policy to increase jobs and wages, resulting in rapid economic growth.

The problem is that the U.S.’s boom is driving recession in other countries. The most extreme case is China. It has served as the world’s factory for over 30 years, but now it’s becoming difficult. China’s industrial production capacity, such as automobiles and oil refining, is sufficient to supply the entire world, but with the U.S. blocking and Europe restraining, there is nowhere to sell.

The importance of the U.S.-China summit lies in how much it can alleviate the global supply chain strain. If China’s exports are blocked, it becomes difficult for U.S. companies to access the Chinese market. Recently, China has responded to U.S. export controls on advanced products with controls on rare earth exports, which can be seen as both countries increasing the stakes for a showdown.

The results of the U.S.-China summit will also greatly affect Europe and emerging countries, which are closely linked to the Chinese economy. In Europe, Germany is struggling so much economically that it is planning the largest economic stimulus in its history. No matter how strong U.S. consumption is, if Europe, the world’s second-largest consumer market, is struggling, there will inevitably be limits to the efficiency of the global economy.

▶The dollar is infinite energy (?)… U.S., growing fiscal burden

During the quantitative easing period, the U.S. government issued treasury bonds and the Fed bought them. After tightening last year, the market has been absorbing treasury bonds issued, not the Fed. As tax revenues have decreased and funds for the transition to a green environment have increased, the U.S. fiscal deficit has continued to grow. The burden of fundraising costs has also increased due to rising interest rates.

The U.S. Congress not only has the right to approve the issuance of treasury bonds but also the power to draft budget proposals. The U.S. is in a state of extreme political confrontation, not unlike ours. The new Republican Speaker of the House is a close ally of former President Trump, who is preparing to run in next year’s election. There is no chance they will be friendly to the government. When the temporary budget deadline ends on the 18th, fiscal instability could be highlighted again.

Rising interest rates are a global phenomenon, not just in the U.S. Almost all countries are facing fiscal challenges. Since the global financial crisis of 2008, developed countries have seen a significant increase in national debt. South Korea and China have increased private debt instead of maintaining government finances, but with aging, potential national debt is about to surge.

Various factors influence interest rates, including global demand and supply systems, production efficiency and technological innovation, and the roles of institutions and fiscal policy. Understanding each of these factors well can increase the accuracy of predictions about the central bank’s base rate. Even if the prediction is wrong, it is very useful for establishing the best response to the situation.