The ‘ghost of 1994’ of the Fed is haunting Asian markets

By William Pesek

Asia will always have complicated feelings about Alan Greenspan.

In the mid-to-late 1990s, the then chairman of the Federal Reserve Bank (Fed) was a real celebrity. His photo was featured in People magazine, Entertainment Tonight and on the front pages of national newspapers. Managing the world’s largest economy brought a brilliant biography of Greenspan by Bob Woodward entitled Maestro.

However, Asia mainly remembers the Greenspan era for precipitating the Asian financial crisis of 1997-1998. It was the Fed’s 1994-1995 tightening cycle – a doubling of interest rates in just 12 months – that set the stage for the Asian crisis.

As the dollar rose, officials in Bangkok, Jakarta and Seoul were unable to maintain currency pegs to the dollar. The subsequent waves of currency devaluations also pushed Malaysia to the brink and almost dragged Japan down as well.

In late 1997, extreme market turmoil dealt a major blow to the then 100-year-old Yamaichi Securities, one of Japan’s big four brokerages. Its collapse has panicked officials in Washington. Both the US Treasury and the International Monetary Fund were concerned not that Japan was too big to fail, but that Japan’s economy might be too big to save.

All this explains why the statements of Jerome Powell – the current chairman of the Fed – on August 26th scared Asia so strongly. Suddenly, the region fears what former Bank of Korea governor Kim Chung-soo calls the “ghost of 1994.”

In the last decade this fear has surfaced from time to time. In 2013, when the Fed’s too-aggressive tightening of monetary policy affected bond markets, Bank of America strategist Michael Hartnett warned of a “1994 repeat.” Lloyd Blankfein, then chief executive of Goldman Sachs, admitted that “I’m worried now as I look out of the corner of my eye at 1994.”

Hence the impact of Powell’s warning that the Fed’s “hawkish” turn will remain “for some time” and cause “some pain” for households and businesses. It also comes amid the Fed’s most aggressive tightening moves since the 1990s.

The yen is already on the brink of 140 against the dollar, a level that New York University economist Nouriel Roubini, aka “Dr. Doom,” warns could force the Bank of Japan to “change policy” with way to increase global unrest.

Over the weekend, Isabelle Schnabel, a member of the European Central Bank’s board, spoke of the challenge of “great volatility” ahead. Already, he said, “the pandemic and the war in Ukraine have led to an unprecedented increase in macroeconomic volatility.”

Now comes the threat of strong central bank tightening. The question, Schnabel said, is “whether these shocks, while significant, will ultimately turn out to be temporary, as was the case with the global financial crisis.”

The bottom line, she warned, is that “the challenges we face are likely to produce bigger, more frequent and more persistent shocks in the coming years.”

With greater impact in Asia than anywhere else. Downward pressure on Asian currencies as the dollar rises, as it did under Greenspan, will cause chaos. Already, markets are talking about a “reverse currency war”.

Over the past two decades, governments from Seoul to Singapore have favored weaker exchange rates to boost exports. Now, as Russia’s war in Ukraine raises the prices of oil, food and other vital imports, Asia fears imported inflation through low exchange rates.

The problem of capital flight also exists. One of Asia’s great disappointments is that in many ways it is paying the price for Powell’s failures. One of them is bowing to former US President Donald Trump’s demands for lower interest rates in 2019, even though the economy did not need support.

In 2021, Powell failed to make tightening moves. He believed too enthusiastically the argument that inflation is transitory. By the time the Fed started raising rates in March 2022 it was too late. Now, as the Fed moves aggressively to rein in inflation, Asia will be a collateral loser.

The Fed’s shift from quantitative easing to “quantitative tightening” has put Asia directly at risk, argued economist Tan Kai Xian of Gavekal Research.

This acceleration of tightening, he says, “which comes alongside further interest rate hikes at a time when the US Treasury has completed reducing its cash balance, will intensify the liquidity squeeze. In addition, US banks are tightening criteria their borrowing costs and so are unlikely to offset this outflow of liquidity. This is likely to weigh on US equity prices, and as real borrowing costs rise and affect demand, it will increase the likelihood of a near-term US recession.”

This will backfire in Asia. Although the region has made progress in weaning itself off exports, creating more dynamic services sectors, any drop in US demand will hit China and the rest of Asia hard. This is really scary.