Say Goodbye To Easy Money And Hello To Higher RiskRudi Dornbusch
The recent Federal Reserve rate hike may turn out to be a prelude to a major change in world monetary policy. Chances are growing for an upturn in German interest rates, and even Japanese rates, dormant for years, may start to rise. Over the next six months the talk of a world upturn in rates may replace the fear of deflation. The end of easy money will be bad news for both asset prices and job growth. But how much trouble is coming?
Last year, U.S. unemployment was low, the growth outlook was so-so, and there was no sign of inflation. Yet there were still calls for a preemptive strike and a hike in rates because of the Fed's past history of being too late and too slow in fighting inflation and because of the long lead times in monetary policy. The Fed deserves credit for not moving in 1996 and permitting another year of job creation.
But now the scene has changed: Price inflation still looks moribund, but wage inflation does not. It has picked up over the past year and, without an offsetting gain in productivity, price inflation is just around the corner. Growth, in particular, continues to be strong enough to reduce unemployment. The Fed cannot rely on the economy slowing down to contain inflation. Fed action was necessary. Just how much depends on the degree of wage pressure that is on the way.
FREIGHT TRAIN MODEL. One view holds that wage pressure is like a freight train--it is slow in coming but very hard to stop. In that case, a 100-basis-point increase in rates may not be enough. A more optimistic scenario gives a lot of weight to competition. The economy is open and U.S. workers remain anxious about losing their jobs to the rest of the world. In this case, wage inflation will ease as growth falls off, and only minor rate hikes will be necessary. The evidence of recent years supports the competition view, while that of the previous decades favors the freight train theory. Over the next few months the markets will have to decide which model is right.
There is another complication. The U.S. clearly has reached the top of the current business cycle, but where are Germany and Japan? After years of near-recession, they appear to be coming back to life. That means short rates of near-zero in Japan will start to rise and German rates, at historic lows, will also move up. None of that is imminent, but the direction is the same as in the U.S. With an end to easy money around the globe, the sweet part of the credit cycle is over. Now, investors will start taking a second look.
In recent years, just about any stock or bond was plausible as an investment. Capital gains were the game. When credit is abundant, as it has been, investors are not very discriminating: Risk premiums collapse, yield spreads get compressed, credit ratings soar, and earnings multiples skyrocket. Bulgarian bonds become plausible, never mind an imminent default; Polish bonds are almost as good as U.S. Treasuries. Now, under the scrutiny of tighter credit, investors will start thinking of risk. Even with the benign scenario--featuring a mild increase in interest rates--investors will ask harder questions if only because they will wait for the other Fed shoe to drop and rates to rise further.
COURAGE AND LUCK. Over the past decade the Fed, led by Alan Greenspan, has shown extraordinary skill in making the impossible happen gently: Big inflation has been controlled, and steady job creation has made dramatic economic restructuring more palatable. All that took skill, courage, and a lot of luck. But now the Fed is announcing the end of the easy money cycle and, as far as growth is concerned, it calls the shots. Of course, if we find out too late that world growth is far more precarious than it seems--no upturn in Germany and Japan, no robust growth in the U.S.--a good strategy will have backfired, and it will be hard to put a new one in place in time.
The present phase is the hardest for policymakers and investors alike. If growth disappears and inflation does not, discontent will be pervasive. There is a real chance of that. And if investors worldwide are skeptical about the easy defeat of U.S. inflation and expect higher rates and less liquidity, a lot of confidence will disappear. Rather than the markets crashing quickly, with ready opportunities for scavengers, we might face attrition. Markets could slide ever so slowly, without investors panicking and running. Yet large losses do build up over time. After the exuberance of a boom decade some of the gains may be given back. This isn't quite gloom and doom. But when liquidity goes, the joy of booming markets does not hang around much longer.