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Why Singaporeans should be worried about rising US interest rates?

The Central Bank of USA, known as the Federal Reserve ("Fed" in short) is responsible for the conduct of monetary policy in USA. As US is an interest rate setter due to its large market for loanable funds and open-ness to capital flows, the monetary policy is USA is mainly interest-rate centred, and is also referred to as the interest rate policy.

The Fed interest rate decision is entirely based on its own domestic economic conductions. Generally, if the economy is showing signs of inflation (or rising prices), the Fed will adopt a tight monetary policy in which it will conduct an open market sale of government bonds to the banks to restrict the amount of money supply and therefore leads to the rise in the "price" of money, which is the rise in the interest rate.

US is showing signs of a strong economic recovery, where unemployment rate has hit a historical 4.2%, and the strong employment data is signs that the economy is operating near full employment. In theory, when workers are in high demand due to strong demand for labour, the wage bargaining power is high, which will feed into higher costs and therefore higher prices in the economy. Accordingly, the central bank will act to slow the rise in demand for labour by slowing the rise in the aggregate demand of the economy.

To do so, the Fed will hike interest rate via the tight monetary policy as mentioned earlier, to raise the costs of borrowing for firms and households, thereby constricting the rise in consumption and investment. This will help slow the rise in aggregate demand, and henceforth slows the inflationary pressures building in the economy.

While Fed interest rate hike decision is meant for its own good, it has ramifications for Singapore, as Singapore is an interest rate taker, due to its small size of the loanable funds market relative to world market for funds, and open-ness to capital flows. It follows that when US interest rates rises, capital flows will move from SG to USA, thereby causing an appreciable fall in the supply of loanable funds in SG, and this causes SG interest rates to rise.

This is where it becomes tricky for policy-makers in SG: Interest rates on housing loans (aka mortgage loans) will rise in tandem with US interest rate hike. This will make it difficult for home borrowers to service their mortgage loans. If US interest rate hike is sharp, it could result in financial difficulty for home borrowers, which could potentially cause a default on home loans.

That said, this is unlikely to happen due to 2 reasons:

1) The Fed has signalled a gradual rate hike, hence it is likely that SG interest rates will rise gradually.

2) The housing loan requirement assumes an interest rate of 3.5% when computing the mortgage loan risks of borrowers, which is significantly higher than the home loan interest rate of 2.2%-2.5% currently.

In view of the above-mentioned interest rate hike, the Singapore government has introduced a slew of additional cooling measures to ensure that households in Singapore are not over-leveraged, which could affect their ability to service housing loans, if the Singapore economy is faced with a double whammy of "rising interest rates" and "falling housing prices".

For further questions on the impact of rising interest rates on housing prices and the economy at large, you may consult our Principal Economics Tutor, Mr Clive Foo during his economics tuition classes conducted @ Toa Payoh Branch.

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