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Low interest rates won't last forever
Worldwide, central banks have for several years kept interest rates at historically low levels, but this is beginning to change
By Christopher Lingle
Thursday, Apr 29, 2004, Page 9
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ILLUSTRATION: MOUNTAIN PEOPLE
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The average global central bank's interest rate is less than 2.4 percent, mostly because of very loose monetary and credit policies. But this is all likely to come to a tragic end, sooner rather than later.
Although central banks can fiddle with setting short-term interest rates, the bond markets will force up long-term rates. And rising yields in bond markets will eventually signal that enough is enough and central banks will have to throw in the towel.
Citing potential destabilizing effect on the economy of mortgage lending growth of over 20 percent a year, the Reserve Bank of Australia recently raised its benchmark interest rate by a quarter of a percentage point. This was followed by a widely expected move by the Bank of England to raise its benchmark rate by a quarter of a point from a 48-year low of 3.5 percent to 3.75 percent.
These steps are likely to mark the beginning of a trend whereby central banks increase borrowing costs after a steady decline in rates since 2000.
Although the Bank of Canada raised its key interest rate in March and April of last year, these were cut again in July and September restoring its key overnight rate to 2.75 percent. The Bank of Japan also raised interest rates to a quarter percentage point from zero in August 2000 but pushed them back down to zero in February 2001.
Meanwhile, the European Central Bank left eurozone rates unchanged at 2 percent, the US Federal Reserve held its rates at the lowest levels in decades and the Bank of Korea left its key call-rate target steady at 3.75 percent.
Despite mixed messages, a reverse law of gravity is at work with respect to interest rates. What goes down artificially must go back toward the levels from which monetary policy caused them to move. With interest rates so low, increases are more likely than are decreases.
US European investors are already factoring in higher official interest rates into the price of stocks and bonds. And recent steps taken by China's authorities indicate a wariness that its economy may be overheating, which would lead to an upward trend in prices.
This long period of easy money pursued by so many central banks will end as they shift their gaze away from warding off recession toward fighting increasing price levels. Despite the hype and hoopla about economic growth, the ongoing signs of recovery will prove to be an unfortunate illusion. As central banks tighten their monetary policy, global interest rates will rise, bringing to an end the impression of a global economic recovery created by artificially low rates.
In response to declining unemployment numbers and narrowing output gaps that cause prices to firm up or begin to rise, central bankers will begin raising short-term interest rates. Then the expectation of higher interest rates pushing up the cost of private-sector borrowing will cause economic growth to slow down.
Impending increases carry significant risks for highly-indebted consumers and businesses while raising the costs of high public-sector debt that will exacerbate government deficits. Artificially low rates in the US and elsewhere have encouraged consumers to incur substantial new debt to buy homes and automobiles. At the same time, businesses have undertaken new borrowing to expand production facilities or make capital improvements. Many of these projects would not have made economic sense at the higher "natural" rate of interest and will eventually fail, especially those financed with variable-rate loans.
Another of upward pressure on interest rates will come from the actions of Asian governments. They tend to prefer a strong dollar in the belief that it serves their best economic interests by keeping their exports relatively inexpensive. In turn, they place a significant portion of their reserves in US securities, especially Treasury bonds. While the value of foreign-exchange reserves held in Asian countries was just under US$800 billion at the start of 1999, the amount is now more than US$1.5 trillion. Japan's stock of foreign-exchange reserves is the largest at over US$555 billion while China is second with over US$320 billion, up from just over US$286 billion at the end of 2002.
Dogged to allow their currencies to appreciate against the US dollar in the face of the massive inflow of dollars has caused the money supplies in Japan and China to swell.
And does this loose monetary policy bring? Well, much less good and much more bad than meets the untrained eye. An illusion of the benefits of monetary expansion is seen through the stimulation of the nominal money demand for goods. But there will be no sustainable gains in the ability of an economy to undergo real expansion.
Unfortunately, the ill effects of monetary expansion will be enduring in terms of prolonged price instability and unwarranted excess productive capacity. In China, it has contributed to the formation of asset-price bubbles as well as rising consumer and producer prices. And so it is that pro-active monetary policy introduces greater economic volatility. In the near future, economic slowdowns will be preceded and accompanied by rising interest rates and higher prices.
Christopher Lingle is professor of economics at Universidad Francisco Marroque in Guatemala and global strategist for eConoLytics.com.
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