ACENTRAL BANKS battling the worst inflation in a generation, they are reversing the easy money policies of the past decade. This week, the Federal Reserve raised interest rates by half a percentage point and announced that it would soon reduce its bond portfolio. The Bank of Australia, which not so long ago forecast that it would keep rates near zero until 2024, surprised investors by raising them on May 3 by a quarter point. When our weekly edition came out, the Bank of England was expected to raise rates to their highest level since 2009.
Although stock prices jumped after the Fed’s rate hike – seemingly relieved that they weren’t tightening faster – financial markets have painfully adjusted to the reality of monetary tightening. Global stock markets fell 8% in April and are down 11% in 2022 as investors anticipate higher rates and weaker growth. On May 2, the ten-year US Treasury yield, which moves inversely to prices, briefly hit 3% (see chart), nearly double its level at the start of the year.
One of the consequences of the tightening of financial conditions is a revaluation of currencies. The dollar is up 7% against a basket of currencies over the past year. America needs higher interest rates than any other big rich country because of its overheated economy and labor market. Higher rates in America increase investors’ appetite for dollars, adding to demand for dollars caused by a drop in their desire to take risks elsewhere as war rages in Ukraine and China battles the virus corona. Most striking was the appreciation of the greenback against the Japanese yen, the only currency of a large rich country in which interest rates do not seem likely to rise any time soon. In real terms, the yen is at its lowest since the 1970s.
Another result is the growth of risk premiums as investors worry about the pitfalls of the new economic landscape. In the United States, measures of the “inflation risk premium,” which increases when prices become difficult to predict, are at their highest level since 1994. Liquidity in the Treasury market appears to be shrinking. The spread on mortgage-backed securities over ten-year Treasury bills has doubled since the start of the year, reflecting concerns that the Fed is actively selling its mortgage bonds. There was an uptick in corporate credit spreads as investors weighed the possibility that higher rates will make it harder for companies to service their debts. And in Europe, the difference between what the German and Italian governments have to pay to borrow for ten years has increased due to the danger that tighter monetary policy will make it harder for Italy to meet its high debts.
A third effect is the poor performance of even diversified investment portfolios. In America, investing 60% in stocks and 40% in bonds produced an average annual return of 11% from 2008 to 2021, but lost 10% this year. While 2021 marked the culmination of the “all rally” in which most asset prices rose, 2022 could mark the start of an “all collapse”, with the end of low rates made possible by low inflation. – the macroeconomic basis for high investment returns.
As investors suffer, monetary policy makers may be tempted to change course. If they stopped raising rates and let inflation soar, bondholders would lose money, but more inflation-resistant assets, such as stocks and houses, would benefit. The dollar would fall, helping the many countries that denominate some of their exports or debts in dollars.
Yet it is the duty of central banks, including the Fed, to react to the domestic economy and prevent inflation from persisting at an intolerable level. Tighter financial conditions are the natural consequence of rising rates, and the adjustment still has some way to go. Investors are still betting that US interest rates will peak at just over 3%. This is unlikely to be high enough to contain core inflation, which has topped 5% in the Fed’s preferred measure. More pain awaits us. ■