End of Cheap Money: Can the World Handle Higher Interest Rates?

By Martin Hesse, and Wieland Wagner

Photo Gallery: Central Banks up a 'Dead-End Street' Photos
DPA

For the last five years, the world's leading central banks have been combatting the crisis with extremely low interest rates and vast bond purchases. Now the American Fed is breaking ranks, as it cautiously suggests a change in its policy -- sending the markets into turmoil.

Fuchinobe doesn't look like the kind of place where speculators have struck it rich. The commuter rail station near the Japanese capital of Tokyo is surrounded by drab apartment buildings and small single-family homes. But the neighborhood is also home to Yuka Yamamoto, 44, a star among Japan's so-called shufu toshika, or "housewife investors."

Yamamoto, a chemical laboratory worker by profession, has written about 40 books with investment tips for housewives. She makes television appearances and recently explained what she thinks about the boom that Prime Minister Shinzo Abe and Bank of Japan chief Haruhiko Kuroda have fueled with their relaxed monetary policy known as "Abenomics."

"I think Abenomics is great," says Yamamoto. The woman, wearing a white blouse and blue lacquered shoes, is pleased with herself. She said that she sold a large portion of her shares weeks ago and that she rode out the most recent mini-crash on the Tokyo Stock Exchange. After climbing by more than 80 percent since the end of November, the Nikkei index dropped more sharply in late May than it had since the 2008 Lehman Brothers bankruptcy. The wild swings have continued in June, with the Nikkei plunging 6 percent on Thursday.

Investors have also been shocked at the speed at which prices have risen and then collapsed on markets in Europe and North America recently.

The rapid changes were triggered by a man they sometimes call "Helicopter Ben" in the financial markets because he once flirted with the idea of throwing money out of a helicopter to fight the crisis. 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.

No More Cash Infusions?

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," says Ulrich Kater, chief economist at DekaBank. "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.

'A Dead-End Street at Full Speed'

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," Jochen Felsenheimer says in his assessment of the situation. The Munich native is managing director at investment management firm Xaia, something of a tamed hedge fund that operates in accordance with stringent German rules.

But the central bankers also cannot continue along the current trajectory. "The policy of cheap money inflates asset prices," says Felsenheimer. 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 like JPMorgan Chase Chairman Jamie Dimon, who said last week that while normalization is a good thing, it's also "going to be scary."

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.

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1. End of cheap money
ewulf 06/13/2013
Like a patient in the emergency room, as long it improves his (her ) conditions ,so it modifies the treatment and eventually may be move out of that emergency room.The key issue is timing. As expected ,the USA economy is moving ahead to a full recovery, faster than its european counterpart. Therefore some time this year, the question will not be whether to end the cheap money era or not ,but the proper coordination process with both EU and Japanese Central Bank to do so,which otherwise would face some expectations of inflationary risk with weaker currencies.-
2. blah, blah, blah
Ethan "Aestu" Farber 06/13/2013
There's nothing here. Bernanke is the emperor without clothes - the man of straw. He doesn't understand the global economy, and he can't control it. All he can do is print fiat money for bankers to stuff in their pockets in exchange for worthless T-bills and mortgages that will never come current. The whole thing is one big scam: the hedge funds that have sucked the blood from the American economy are now devouring the world itself: from corporate raiding to driving up the prices of commodities, making the lives of common people everywhere progressively harder even as technology continues to develop, providing nothing of value in exchange for the speculatory profits they reap. What they do can't even be called speculation because the prices always go up. The world itself is one big captive market, and Bernanke is nothing but the front man. Interest rates won't come down because they can't. The mortage market won't normalize because it can't. There is nothing in the American economy to generate wealth on the scale necessary to keep its hideous inefficiency afloat, and American voters won't accept the fundamental changes in their way of life necessary to fix things because they believe the greed of others will serve their own. It's pathetic, and all those of us with common sense can do is hold on and wait for the Ponzi scheme to crap out.
3. Japan
StockGaming.com 07/09/2013
"Can the World Handle Higher Interest Rates?" Not according to Kyle Bass. If interest rates go up 1%, Japan is toast. Eventually, they won't have enough tax revenue to pay the interest on their debt. Japan will become the next crisis.
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