Lee Jong-Wha says that after supporting economies during the global economic crisis, now the global recovery gains momentum, the time has come to begin tightening monetary policy

By Lee Jong-Wha*

The region’s export-oriented emerging economies are benefiting from the recovery in global trade, while its largest players – China, Japan, and India – remain dynamic.

Throughout the region, accelerating economic growth, together with positive corporate earnings expectations and persistent capital inflows, are driving up stock prices. And inflation will remain in check, owing largely to the slow rise in wages and import prices.

Yet there remains plenty of cause for concern.

For one thing, Asian markets will undoubtedly face capital-flow volatility, driven by the major advanced economies’ monetary policies. For another, large debts could increase financial risk in some Asian economies, damaging growth prospects. The region’s central banks will be integral to managing these risks.

In the wake of the global economic crisis, Asia’s central banks, like their counterparts in the advanced economies, assumed a leading role in supporting domestic growth. But, as the global economic recovery gains momentum, the time has come to begin tightening monetary policy.

The major advanced economies’ central banks are already on that path. The European Central Bank, the Bank of England, and the Bank of Japan are moving to rein in their swelling balance sheets and raise interest rates. But it is the US Federal Reserve that is leading the way.

With low growth in wages and consumer prices keeping inflation subdued, the Fed is likely to continue pursuing gradual interest-rate hikes. But if, as is likely, the tax cuts recently enacted by President Donald Trump and congressional Republicans accelerate economic and price growth enough to raise the risk of economic overheating, the Fed will need to act more assertively.

This broad monetary tightening will have a profound impact on Asia’s emerging economies, which are highly integrated into global markets and thus open to foreign capital flows. In particular, changes in global liquidity conditions are likely to send Asia’s financial and foreign-exchange markets on a roller-coaster ride, fueling pressure to keep up with interest-rate hikes in the advanced economies.

To be sure, some economists still argue that Asia’s central banks should maintain low interest rates, owing to persistently subdued inflation. They worry that, at a time when many households and businesses remain laden with debt, a sharp rake hike would undermine consumption and investment, potentially impeding economic growth.

But the truth is that large debts and overvalued risky assets are the result of sustained monetary expansion. If central banks continue to postpone interest-rate increases for much longer, asset bubbles might develop – not just in the stock and housing markets, but also in, say, virtual currencies – leading to another financial crisis.

The best way to avoid such an outcome is for emerging Asian economies to increase rates gradually and predictably. This does not mean that Asia’s central banks should simply bow to external pressure. Rather, each central bank should pursue monetary-policy normalization at a rate appropriate to safeguarding macroeconomic stability without damaging domestic economic activity.

The good news is that Asia’s central banks seem to recognize this, and are already moving toward tightening, with the Bank of Korea in the lead. On November 30, against a backdrop of rapidly accumulated household debt and distortions in capital allocation, the BOK raised rates by 25 basis points, from a record low of 1.25%.

Monetary authorities in countries like Malaysia, Taiwan, Thailand, and the Philippines are expected to follow suit, timing their interest-rate hikes according to economic conditions. In China, too, monetary tightening will be needed to mop up excess liquidity and reduce leverage. Otherwise, according to Zhou Xiaochuan, the governor of the People’s Bank of China Governor, the country might face a “Minsky moment,” in which excessive optimism and debt-financed investment culminate in financial crisis.

The main potential hitch in this process is political: because ultra-low interest rates amount to an easy form of economic stimulus – much easier than, say, labor, tax, or regulatory reforms – politicians might put pressure on central banks to delay rate hikes. But central banks, leaning on their hard-won independence, must not succumb. Though the active monetary policy used since the global economic crisis has caused some to question central-bank independence, compromising it for the sake of political accountability would, as Barry Eichengreen has put it, be tantamount to “throwing the baby out with the bathwater.”

Standing up to politicians may not be easy for central bankers, not least because, in many countries (including China, Indonesia, Japan, South Korea, and Taiwan), the central bank’s governor is due to be replaced or reappointed in the coming months. The new leaders will need to enter their positions with confidence, and remain steadfast in their decision-making in the face of large-scale uncertainty.

That said, central bankers should not be solely responsible for supporting low and stable inflation and maintaining financial stability. They certainly cannot be expected to drive job creation and output growth in the long term. That is why they must cooperate with policymakers, including fiscal authorities and financial regulators, to ensure the right mix of monetary and fiscal policy, as well as structural reform.

A decade after the global economic crisis began, the world economy is on the path toward normalcy – a path that demands the gradual tightening of monetary policy in Asia and the West alike. It is now up to central banks to meet that demand, without derailing the recovery.

Lee Jong-Wha is Professor of Economics and Director of the Asiatic Research Institute at Korea University. His most recent book, co-authored with Harvard’s Robert J. Barro, is Education Matters: Global Gains from the 19th to the 21st Century. Copyright: Project Syndicate, 2018, published here with permission.