End of Cheap Money: Can the World Handle Higher Interest Rates?
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."
"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.
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.
- Part 1: Can the World Handle Higher Interest Rates?
- Part 2: 'We Are Optimistic'
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