David Beckworth recently conducted an excellent interview of Mike Bird, which is full of fascinating observations. At one point they were discussing the Hong Kong currency board, which since 1983 has fixed the exchange rate between the Hong Kong and US dollars. This exchange caught my eye:
Beckworth: Yeah. So, interestingly, the Fed sets monetary policy for Hong Kong effectively, right?
Bird: Yup. Absolutely, which is very noticeable in the Hong Kong housing market over the past 10 years or so.
I think that’s right. But this doesn’t necessarily mean what you think it means. While the US is setting the monetary policy in Hong Kong, that policy is nothing like monetary policy it sets in the US.
Because of arbitrage, interest rates tend to be roughly the same in any two free market economies with fixed exchange rates and open capital markets. Thus when the Fed moves its target short-term interest rate up and down, interest rates in Hong Kong tend to move in unison.
However, interest rates are not monetary policy. What matters is the difference between the policy rate and the equilibrium interest rate. For simplicity, let’s assume the equilibrium rate is the interest rate that maintains 2% inflation. (In practice, employment also affects the equilibrium rate.) In the US, the Fed moves the policy rate up and down in an attempt to keep interest rates close to equilibrium. This doesn’t work perfectly (inflation fell to 0% in 2009) but overall the Fed does a reasonably good job of keeping inflation close to 2%.
But the equilibrium interest rate in Hong Kong is very different from the equilibrium rate in the US. As a result, there are often wide gaps between the actual interest rate in Hong Kong and the equilibrium rate. This causes wild swings in inflation, from double digits to negative 4%. These wild swings in monetary policy result in the Hong Kong economy being dominated by demand shocks, one of the three prerequisites for the Phillips Curve model to work.
Interestingly, Hong Kong also has the other two prerequisites for a stable Phillips Curve. First, inflation expectations are stable due to the US dollar peg combined with the Fed’s 2% inflation target, despite big fluctuations in actual inflation. And second, the natural rate of unemployment is stable due to Hong Kong’s relatively laissez-faire labor market regulations. Put the three together and you have one of the few countries where the Phillips Curve still holds:
We should all thank Hong Kong for being willing to perform a natural experiment as to what would happen if you arbitrarily used monetary policy to create large swings in actual inflation, in an economy with stable inflation expectations (roughly 2%) and a stable natural rate of unemployment (roughly 4%).
PS. This also explains why the Phillips Curve is such a bad model. There are very few countries where all three Phillips Curve prerequisites hold true. And the US is not one of them. The Fed should stop relying on the Phillips Curve.