The fact that all major economies are engaged in tightening monetary policy is of great significance.
By PINCHAS LANDAUmoney good 88(photo credit: )
The one clear trend at work throughout the developed economies is the rise in interest rates. Whilst not new - the US Federal Reserve has been raising rates virtually non-stop since mid-2004 - the important features of this trend are that it is both deepening and widening.
Deepening, in that the length and extent of the upswing in interest rates is proving greater than had been generally thought. As recently as last fall, the consensus expectation was that the Fed would stop raising rates at 4.5%, in January or, in the worst case, at 4.75% later this year. Now, however, no one expects the Fed to stop at the current rate of 4.5%. The discussion has moved on to whether 5% or 5.25% will be the top of the upswing.
But there is no guarantee that this debate will also prove optimistic. On Wednesday, the President of the St Louis Fed., one of the regional banks that comprise the US Federal Reserve System, said it was better to raise rates too much than too little. This is typical central bank thinking, and it confirms the probability that the Fed won't stop until the economy is definitely slowing - on its way to at least a minor recession.
Meanwhile, the European Central Bank (ECB) has joined the rate-raising set, with just two moves to date but at least one or two more on the way. Of course, there are big differences between the states of the European and American economies, but the fact is that the ECB is now pushing rates upward, and the only question is how far and at what pace. Most of the independent European central banks, notably the Swiss, are also oriented towards higher rates. The only exception is the UK, where rates peaked last year and are expected to fall - but this expectation is also proving optimistic, so that the overall trend holds true there, as well.
Most recently - yesterday, to be exact - the Japanese central bank finally joined the global trend. Interest rates in Japan have been zero for several years, as the central bank has fought the long-running deflation in Japan via a policy known as "quantitative easing." In practice, this has meant printing incredible amounts of money in an effort to flood the economy with 'free' money and thereby spur demand. Eventually, consumer prices have stopped falling and may even rise marginally this year, so that the bank - after talking about it for many months - has now announced that it is taking the plunge and beginning to turn the money tap off. Even so, this will be a slow and cautious process, so that interest rates will only move above zero later this year. But, once again, the direction is what matters and it is up.
The fact that all the major economies are engaged in tightening monetary policy is of great significance to the entire world. The fact that the Americans are well-advanced in this process but apparently intend to continue it, is even more important because it is the US - in particular, the American consumer - which has been the most important player in the global economy in recent years.
The steady increase in the cost of short-term money has fed through into longer-dated interest rates.
The yield curve, measuring the cost of money for different durations, is now flat from two years through 30 years. Normally, interest rates rise as the duration of the loan rises, to take account of the greater risk involved. The fact that the yield curve is flat and may soon invert (so that short-term money is more expensive than long-term funds) is seen as a sign of impending trouble for the economy. Indeed, in the all-important housing market, indications that the boom is fading have been building up for months. The key question now is whether the excess supply and slowing demand will cause a sharp drop in prices, or whether a 'soft landing' is possible.
The fate of the housing market will determine in large extent how the US economy fares in 2006-2007. Meanwhile, however, the rising cost of money will impact the rest of the world, too - and possibly very soon. The massive boom in emerging market equity markets, including that of Israel, has been fuelled by the availability of endless quantities of cheap money.
As this money becomes less cheap and there is less of it (reduced supply causes price to rise - see Introduction to Economics), these markets will be exposed to potentially sharp falls, of precisely the sort that have occurred in several overpriced markets in recent weeks.
In short, if money makes the world go round, when there is less of it, the world and its economy will go round slower.
landaup@netvision.net.il
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