Hawkish Fed Makes the Market Crash
The Federal Reserve (The Fed), the United States’ central bank, has aggressively raised interest rates this year. The first increase in the benchmark interest rate this year will be in March 2022 by 25 bps to 0.5 percent. Then, in May 2022 the interest rate returned to 50 bps to the range of 1 percent. Until June 16, 2022, the Fed finally raised its benchmark interest rate aggressively, by 75 bps to 1.75 percent. The total increase in interest rates that occurred gradually was 150 bps, which was considered the most aggressive growth since 1994. This was done to suppress inflation in the United States, which was the highest inflation in 41 years. As of May 2022, inflation stood at 8.6 percent (year-on-year), which mainly came from food and energy prices.
The Fed’s contractionary policy was immediately responded to by the global economy with the decline in commodity prices, movement of capital flows, strengthening of the dollar, and others. The magnitude of the influence of the decisions of monetary institutions on the economy is an important matter that needs to be discussed further.
Economy Condition After Hawkish
The Fed’s contractionary policy responded negatively to the stock market. In May last year, the main stock market in the United States, Wall Street, experienced a compact decline with the Nasdaq bourse corrected by 4.99%, the S&P 500 Index corrected 3.56%, and the Dow Jones index corrected by 3.12%. The decline that occurred was mainly triggered by the fall of technology stocks, such as shares of Meta (the parent company of Facebook), Apple, and Amazon which fell by 4.3%, 1.7%, and more than 1% respectively, while Tesla and Nvidia fell by around 4 %. These depressed technology stocks can’t be separated from the direction of interest rates. Technology stocks tend to be sensitive to an increase in interest rates because it will trigger an increase in the cost of borrowing, especially when the performance and earnings of technology companies, such as Facebook and Netflix, are declining. Therefore, investors will tend to choose stocks that are more defensive against rising interest rates, such as consumer goods stocks.
In financial markets, the Fed’s contractionary policy has resulted in a narrower spread between risk-free investments and other investment instruments. The implication is that there is an outflow of investor funds from developing countries in an effort to adjust portfolios, such as in Indonesia. This is reflected in Indonesia’s capital and financial account deficit from the 4th quarter of 2021 to the 1st quarter of 2022. Indonesia’s capital and financial account experienced a deficit in the 1st quarter of 2022 of USD1.7 billion. Transactions that contributed to the deficit were portfolio investment transactions with a deficit value of USD2.9 billion. This means that the owners of the funds are moving their assets out of Indonesia, which is a developing country, amid the uncertainty of global financial markets as a result of the geopolitical conflict between Russia and Ukraine.
Furthermore, the capital outflow phenomenon has an impact on the decline in the exchange rate. The large number of investors who issued their funds from Indonesia caused a sell-off of the Rupiah which resulted in the depreciation of the Rupiah. From January to mid-June 2022, the rupiah has depreciated by 4.1%, which currently costs around Rp. 14,800 per USD. The decline in the rupiah exchange rate is still relatively safe compared to other countries that also experienced depreciation, for example the Turkish Lira which depreciated 30.1%, the Argentine Peso which depreciated 19.7%, and the Malaysian Ringgit which depreciated 5.7%. Several factors, such as foreign exchange reserves and trade performance, were able to withstand the pull of depreciation.
The world economy which started to recover after the Covid-19 pandemic was hindered by contractionary monetary policies that dampened economic enthusiasm. The phenomenon of capital movement towards haven haunts developing countries with exchange rate depreciation in several regions. The Fed’s decision to cut interest rates quickly can lead to a potential economic recession. This illustrates that monetary institutions are one the important figures regarding the continuation of the world economy in the future. Therefore, an understanding of monetary policy and how the central bank system uses policy needs to be discussed further.
What is Monetary Policy?
Monetary policy is an instrument used by monetary institutions to control the economy through controlling the money supply, both expansionary and contractionary. According to Bank Indonesia, expansionary monetary policy is a policy taken by the central bank to encourage economic recovery during a recession. Meanwhile, contractionary monetary policy is a policy that aims to prevent overheating in the economy. The Hawkish Fed signaled that the central bank of the United States had issued a contractionary monetary policy that made the benchmark interest rate rise 150 bps to 1.75%. The impact on the economy, especially the financial market, is the withdrawal of funds by investors. The stock market tends to be down due to reduced public confidence and also the cost of investing is higher. To maintain the value of their assets, the public and investors will generally be more interested in putting their money in savings or assets such as gold.
Interest rate stability is important because fluctuations in interest rates can trigger uncertainty in the economy and make it difficult to plan for the future. Financial market stability was also driven by interest rate stability, as fluctuations in interest rates created great uncertainty for financial institutions. Rising interest rates incur large capital losses that will cause financial institutions to go bankrupt if conditions persist.
Transmission and Mechanism
The influence of monetary policy on the economy can be through several channels. Primarily, the central bank influences the supply of money through interest rate policies to control bank credit, which continues in investment activities. In addition, economic control can be carried out through the exchange rate control channel, the central bank trying to stabilize the exchange rate to support foreign trade activities that can stimulate the economy. Monetary institutions can also control inflation and economic growth by issuing predictive statements to control expectations.
Furthermore, the central bank can directly control monetary policy instruments, namely through open market operating policies, minimum statutory reserves, discount loans, and interest rates for reserves. However, understanding the instruments and strategies in implementing monetary policy does not give us information on whether the policy is loose or tight. We can see the policy instrument (policy instrument) as a variable that moves against the central bank’s instruments and shows the position (loose or tight) of monetary policy. The Central Bank has two basic types of policy instruments: reserve aggregates (total reserves, non-lending reserves, monetary base, and non-lending basis) to regulate the money supply and interest rates (benchmark interest rates and other short-term interest rates).
In determining the policies to be implemented, monetary institutions consider core inflation first. For example, in Indonesia, Bank Indonesia is currently still leaning towards economic growth. When interest rates can be held longer, economic growth is more spurred. If viewed based on the current movement, there is no significant impact even though there is a change in the probability of a 100 bps rate hike. The weakening of the rupiah can be said to be still very small. The JCI has rebounded even though it had fallen. This indicates that there is no excessive fluctuation in the domestic market, so Bank Indonesia is still reviewing how core inflation and capital outflows will be going forward as well as movements in the rupiah exchange rate to determine when it is time to raise interest rates.
Final Words…
The brake lever has been pulled with contractionary decisions taken by central banks around the world. The easy money era with low-interest rates to stimulate the post-pandemic economy has slowly come to an end. The war between Russia and Ukraine disrupted supply chains around the world which had an impact on the inflation of key commodities such as energy and food. Inflation which should be accompanied by an increase in income did not occur because of the cost push pressure caused by sanctions related to the war. The world must be ready to tighten their belts even though their stomachs have not been filled after fasting for two years since the first case of the corona was discovered in Wuhan. The bitter pill must be swallowed to avoid mass hunger, increasing poverty, and decreasing the living standards of the people.
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AUTHOR (S) :
Dhimas Hadi Firmansyah (EconLab)
Syafina Hela (EconLab)
Vela Fadhila Amijaya (EconLab)
Fichrie Fachrowi Adli (HIMA EP Unair)
Avicenna Deskartian Margani (HIMA EP Unair)
