While the Bank of Japan has just announced that it intends to pump even more money into the system, US Federal Reserve Chairman Ben Bernanke wants to slowly wean the economy off the cheap money that has intoxicated investors for years. That, at least, is what many investors believe. And because activity in the markets is based primarily on expectations, stock and bond prices have fallen recently, while long-term interest rates have gone up, even though none of the major central banks has made any changes to their current, ultra-low prime lending rates. The monetary watchdogs are also continuing to buy government bonds and other securities in a big way.
But investors are worried about withdrawal. They wonder whether the economies in the United States, Europe and Japan are robust enough to manage without cash infusions, or even with a somewhat reduced dosage. When the financial crisis escalated in 2008, the Fed, the European Central Bank and other central banks began their cash therapy. Almost in lockstep, they reduced prime rates to close to zero and began buying up bonds on a large scale. To this day, the leading central banks have inflated their balance sheets with such practices to $10 trillion (€7.5 trillion).
But now something is changing. For the first time, it looks as though one country, namely the United States, is leaving the crisis behind. And, also for the first time, a central bank, the Fed, is showing that it is thinking about normalization. But will it also transform the thought into action? Can it even do that without the financial markets going haywire? So far, only the US economy has stabilized to a sufficient extent that a shift in monetary policy seems conceivable. And even there, the recovery is based on cheap Fed money and could collapse if deprived of this foundation.
Even if the experiment works in the United States, a shift in Fed policy would also bring about consequences in Europe and Asia -- for banks, governments, investors and depositors. There, too, prices could fall and yields could rise. Crisis-ridden countries could once more run into problems securing financing, and banks could be burdened with new write-offs.
The central banks have driven into a dead-end street at full speed. They can't turn around. All they can do is slowly apply the brakes. But the central bankers also cannot continue along the current trajectory. The policy of cheap money inflates asset prices. The later the normalization occurs, the more painful it will be. And because Bernanke also knows that, the Fed chief began a very gentle withdrawal process in May. "In the next few meetings, we could take a step down in our pace of purchase," Bernanke told the US Congress last month.
The Fed currently spends $85 billion a month to buy US treasury bonds and mortgage-backed securities. This has enabled it to keep mortgage rates low and reinvigorate the real estate market. Merely a hint from Bernanke that the Fed could "take a step down" has caused 30-year mortgage rates to rise from 3.35 percent in early May to almost 4 percent recently. Rates on 10-year Treasury notes went from 1.7 to 2.1 percent. Although these numbers are still very low compared to historical rates, the development scares bankers.
Bernanke is familiar with these fears, which is why he added that a restriction on bond purchases is not automatically the end of a relaxed monetary policy. It was his way of bringing calm to the markets while preparing them for harsher policies in the future.
In contrast to Europe, the debts of banks, businesses and private households have declined in the United States, while government debt has increased. If interest rates went up, it would become more difficult for the government to reduce its debt. On the other hand, the American financial sector could handle a moderate rise in interest rates. But if the ECB stops its cash infusions, many banks in the euro periphery will be threatened with insolvency.
But the Bank of Japan remains especially uninhibited as it continues to flood the markets with money. The central bank's new governor, Kuroda, is buying up more than 7 trillion yen (€54.5 billion) in government bonds each month. That's 70 percent of all new bonds. Whether Japan will manage to emerge from its ongoing crisis thanks to Abenomics doesn't just depend on the central bank, which has already kept interest rates at close to zero since the mid-1990s without any visible success. The financial markets are waiting for reforms and have been disappointed by announcements to date.
This could help exporters in the euro zone. But last week it was the dollar that fell, because investors still aren't quite sure when the shift in interest rates will actually happen and what its consequences will be. This makes it difficult for investors to adapt to the changes. The markets that recently benefited the most from the glut of money will be the most strongly affected -- in other words, stocks, bonds and real estate.
But for people buying real estate, rising interest rates will eventually pose a problem, because the low rates at which they have borrowed money in recent years are usually locked in for only five or 10 years. After that, the mortgages are generally renegotiated.
Even for life insurance customers, an interest increase, depending on how drastic it is, can be more of a curse than a blessing. Insurance companies have been complaining about low interest rates for years, because it forces them to invest most of their customers' premiums in relatively safe bonds, which are hardly profitable at the moment. On the other hand, these funds are also locked in at low bond yields for years. If interest rates go up within a few months, the investment strategists for the insurance companies have few options. This means that their customers also have little to gain from a boom in interest rates, at least in the short term.
Central bankers know what years of low interest rates and all the resulting cheap money have done to the markets. But eliminating these "sweets" again is difficult, says one expert, who isn't willing to rule out a scenario like the one in 1994. At the time, the Fed's decisions on monetary policy triggered a global tremor in bond markets.
So what is needed so that central banks can finally regain the freedom to impose tighter monetary policy without shocking the markets? Banks, households and firms need to redouble their efforts to deleverage and to repair their balance sheets, while policymakers must redouble their efforts to enact far-reaching reforms. Progress in this area would also enable central banks to normalize their monetary policy.
By Guylain Gustave Moke
Photo-Credit: AFP: US Federal Reserve chairman Ben Bernanke