The recent interest rate cut by the United States Federal Reserve presents opportunities and challenges for central banks in Asia and the Pacific. Policymakers must adopt a balanced, country-specific approach to navigate potential inflationary pressures, exchange rate volatility, and capital inflow dynamics.

The United States’ Federal Reserve kicked off a long-anticipated monetary policy loosening cycle at its September Federal Open Market Committee meeting, cutting interest rates by 50 basis points. Committee members project another 50 basis points of cuts this year, and that Fed loosening will continue in 2025.

This could have significant consequences for the global economy, including for developing economies in Asia and the Pacific.

Inflationary pressures have continued to decline in the region this year, as commodity prices stabilised and the lagged effects of last year’s monetary tightening took hold. As a result, most of its central banks have paused their hiking cycle, with some switching to policy rate cuts. Others may now follow suit.

In shaping their policy stance, central banks in emerging economies need to take account of interest rate differentials with the US, which impact capital flows and exchange rates.

However, capital inflows could also present some challenges, as significant swings in short-term portfolio investment could increase financial market volatility.

The Fed rate cut opens up the opportunity for more of the region’s central banks to loosen policy to stimulate domestic demand and growth, without triggering capital outflows and exchange rate depreciations.

Still, since the pace and length of the Fed loosening cycle remains uncertain, an appropriate policy response in Asia and the Pacific will require caution and a careful balancing act, for a number of reasons.

Alternatively, central banks in the region could continue to maintain a relatively tight monetary stance—for example by cutting interest rates with a lag or less than proportionally with respect to the Fed.

In such a case, the lower interest rates in the US could increase capital flows to Asia and the Pacific, as investors adjust their portfolios toward assets with more attractive yields. This could boost equity and bond markets across the region, providing some breathing space to more vulnerable economies.

However, capital inflows could also present some challenges, as significant swings in short-term portfolio investment could increase financial market volatility.

Additionally, higher capital inflows may result in exchange rate appreciations vis-à-vis the US dollar in the region. This would benefit economies heavily dependent on oil and other commodity imports, reducing price pressures and improving trade balances. For economies with high US dollar-denominated debt, the depreciation of the US dollar would make it easier to sustain the debt burden.

On the other hand, exchange rate appreciations would boost imports, with potentially negative effects on current accounts. In the medium term, stronger currencies could also hamper export growth, particularly for economies reliant on exports of traditional manufacturing goods, such as garments or textiles, which depend mainly on price competitiveness.

This variety of potential effects and channels suggests that policy responses to the Fed loosening cycle in Asia and the Pacific will need to be country-specific and nuanced, and include a combination of the following measures.

As well as adjusting interest rates, monetary authorities in the region could rely on targeted measures, such as on banks’ reserve requirements, to affect financial and liquidity conditions. Forward guidance can also be an effective tool to anchor inflation expectations and reduce uncertainty and financial volatility, by clearly laying out the future path of monetary policy for market participants and economic agents.

Pakistan’s remittance inflow stands at $2.9bn in August, up 40.5% year-on-year

For economies receiving increasing capital inflows, well-developed financial markets are key to absorb the inflows and turn them into productive investment in the domestic economy. Policy action should focus on increasing competition, efficiency, and transparency in the financial sector, with the central bank or other overseeing independent authority providing adequate supervision.

To deal with the risks associated with rising capital inflows, capital flow management measures and macroprudential policies can be used, including measures aimed at mitigating exposure to currency mismatches. Where capital inflows result in excessive currency appreciation, targeted intervention in foreign exchange markets could help reduce volatility, while also increasing foreign exchange reserves.

Fiscal policy could be used the cushion the impact of falling exports. Depending on fiscal space, stimulus could be directed at several objectives, including boosting consumer spending; incentivizing activity in particular sectors with stronger multiplier effects on the rest of the economy; and infrastructure, energy-saving, climate-adaptation, and other projects aimed at addressing structural gaps, which would also boost the economy’s productive potential.

Policymakers will need to adopt a flexible approach, remaining vigilant and proactive in taking advantage of the opportunities and addressing the risks.

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