They say talk is cheap, although for the past few years, it hasn’t been quite as cheap as cash.
For months now, the world’s money mandarins have been sounding the alarm that the great global experiment on free money is drawing to a close. And in recent weeks, their cries have become more shrill. Interest rates will be rising sooner, faster and to higher levels than previously expected.
Last week, it was Jerome Powell, head of the most powerful central bank, the US Federal Reserve. He was backed up by Tiff Macklem, boss of the Bank of Canada. And, on Tuesday, we’ll hear from our very own Philip Lowe, the big kahuna at the helm of the Reserve Bank of Australia.
Their warnings have created panic on global stock markets. Some of Wall Street’s biggest technology stocks are down a whopping 30 per cent from their peak and the carnage has spread across the globe. For a brief time last week, the Australian market dipped into correction territory after shedding more than 10 per cent from its August 2021 peak.
There now is little doubt that the pandemic has changed the course of history, or at least been the catalyst for a long-overdue shift in the tectonic plates of the financial world.
But before you hit the panic button, it might be worthwhile to sit back and chill just a little. For unless you’ve plunged everything into ultra high-risk investments, like technology companies that don’t earn any money, the chances are you’ll survive the shift just fine.
For a start, the turnaround started just on a year ago. It was just that central banks wouldn’t believe it and did their best to ignore it, loudly proclaiming that interest rates would not be lifted for years. Share traders, emboldened by the assurances, kept on blindly buying, pushing stocks further into orbit.
Unfortunately, the interest rate horse already has bolted and the official rate rises that are about to begin merely are playing catch-up.
Central banks lost control a year ago
It’s an easy mistake to make; to believe central banks are all-powerful and dictate the direction and size of interest rate movements. And for most of the past half-century, they did.
But they lost control a year ago, and while they remain a powerful force in the marketplace, they are far from omnipotent. Check out the graph below, at the market where interest rates really are set; that dictate to banks the rate at which they can borrow and lend.
See that little blip at the end? That’s the turning point in a 40-year cycle of rate cuts that happened around February last year.
A year ago, the 10-year government bond rate – often called the risk-free rate because it’s an IOU backed by the government – was sitting at just 0.6 per cent, not too far above the RBA cash rate of 0.1 per cent.
For the past 12 months, bond market traders have ignored the Reserve Bank’s insistence it would keep rates on hold until 2024. Instead, concerned about rising inflation, it pushed market rates higher, which explains why all those incredibly cheap fixed-rate mortgages suddenly disappeared. Last week, that 10-year government bond punched through 2 per cent.
It’s been the same story across the globe. In Germany, until last week, government bond rates for years have been below zero. That’s just ludicrous, conflicting with 5,000 years of human history and any sense of logic.
It’s also dangerous. Ultra-low, zero and negative interest rates have distorted global finance, pushed investors into ridiculously risky investments and artificially inflated stock prices and real estate. They’ve also punished savers, anyone who wanted to park money with minimal risk.
The turning has been forced upon us, not by central banks, but by the spectre of inflation that has been dormant since the 1990s.
Why has inflation returned?
Partly, it is because the forces that relentlessly drove it lower have abated.
Much of it is to do with China. The Middle Kingdom’s rise to power came about from its industrialisation. It rapidly shifted from a rural-based economy to an export-based factory powerhouse.
Marshalling its low-cost labour force, it produced everything from clothing and shoes to tools and heavy machinery and ultimately, high-tech communications. And because they were produced at such a massive scale, it could export them at prices way below the cost of production in the developed world.
Whole industries pulled stumps and shifted to China. Essentially, its biggest global export was lower prices.
That had another effect. As workers across the developed world lost their jobs, unemployment rose, union power was crushed and wages stagnated. Add in the rise of the internet and the digital economy, and even skilled workers could be sourced offshore and online, further depressing developed world wages.
That allowed central banks, which took over running the global economy in the 1980s, to continue cutting rates, especially during a crisis. There was the Asian financial crisis of 1997, the Dotcom bust of 2001 and the global financial crisis of 2008. Until finally, they ran out of ammunition with interest rates at zero.
Those trends largely have run their course.
Rising geopolitical tensions have seen calls for more production at home, regardless of cost. And China’s shift into the developed world has seen its own workers demanding higher wages, limiting the extent to which it can keep a lid on export prices.
Add into that turbulent mix, the more immediate factors. The COVID-inspired global recession resulted in a deluge of government stimulus and trillions of dollars in newly minted cash in a bid to alleviate the impact of lockdowns and sickness.
As the world emerged from recession last year, all that extra money turbocharged demand for goods, the supply of which was constrained by shipping problems and production delays. Prices began to soar.
America’s inflation rate now has leapt to 6.8 per cent, its highest since 1982. Across the Tasman, New Zealand — which already has raised interest rates — last week notched up a 5.9 per cent hike in consumer prices, the biggest in three decades. Here at home, our headline inflation clocked in at 3.5 per cent for the December quarter, far higher than expected.
No pay rise, no rate hike
If ultra-cheap cash created all these asset bubbles — soaring house prices and stock markets at nosebleed levels — then, surely, logic would dictate that higher cost cash will burst them and we’ll all be ruined.
That’s a distinct possibility. But it’s more remote than many would have you believe. Stocks may have further to fall, especially those companies carrying too much debt or with little earnings.
But for all their talk right now, central bankers have been remarkably timid about pushing rates higher. And for good reason. They’re acutely aware of the consequences of getting this wrong, particularly when it comes to housing.
Dr Lowe, who makes his first outing this week, will be keen to hammer home the point that we’ll need to see wages growth before there’s any substantial rise in interest rates. So, by the time your mortgage rate is hiked, maybe later this year, you should be able to cover it with a bigger pay packet.
That’s going to be crucial for the legion of first home buyers, many of whom took on loans six times their incomes, who took the plunge last year in a borrowing spree that was encouraged by our monetary mandarins.
In any case, much of our newly acquired inflation is a result of global shortages, of building materials and fuel. It’s not being driven by sustained excess demand.
Pushing interest rates higher right now wouldn’t lower those prices. It would probably just push the economy back into recession, which would mean rates would need to be cut again.
Unemployment has dropped to 4.2 per cent and there is anecdotal evidence that wages have started to rise. But don’t expect official rate hikes until late this year until there is firm evidence that wages finally have broken out of the doldrums.
Unwinding the distortions created by free money won’t be easy, nor will it be quick. And it won’t come without pain or casualties. But it is entirely necessary.