Nobody ever claimed it was easy to be a central banker, but at least your guiding principles used to be clear enough. If you spotted signs that inflation was growing uncomfortably strong, you would hike interest rates to slow the economy and rein in rising prices. Conversely, if you detected a slowdown in business activity, you would lower rates to encourage consumers to borrow and buy stuff. Timing exactly when to move could be difficult, but the broad strategy was extraordinarily simple.
Not so these days. Old rules no longer apply in a world where interest rates have been hovering at historic lows for close to a decade. Managers and investors who believe they know how central bankers operate should brace for some unexpected twists over the years ahead.
Right now, for instance, both the Bank of Canada and the Federal Reserve Bank in the U.S. appear resolved to raise rates. At least by the usual rule of thumb—the one that says you raise rates in response to rising inflation—their determination makes no sense. Inflation is low and has yet to move above the 2% mid point of the central banks’ target ranges.
Granted, the hard-liners can muster a credible argument that the North American economy is close to full capacity. With a bit more effort, they can construct a tale that inflation could be on the verge of taking its first serious jump in a long time. But, really, guys? If that’s your best argument for boosting interest rates, it all seems a bit desperate.
After years of plodding growth, an outburst of old-fashioned boom times—like Canada’s sizzling first half—comes as welcome news. Running the economy at a red-hot pace for a while would merely help to bring the North American economy back to the trend line it was tracking before the financial crisis. Even if inflation were to spike above the desired 2% level for a few quarters, there would be plenty of time to hike borrowing rates and force it back down before it did any serious damage.
Far more dangerous than a burst of inflation would be if central bankers hiked rates prematurely and drove the economy into a Japanese-style deflationary coma. Strangely, though, that risk goes unmentioned.
So what does account for central bankers’ newfound insistence that rates must go up and right now? The simplest explanation is that policy makers are worried about asset prices. From Canadian home prices to U.S. stock prices to European bond prices, many investments appear to be in bubble territory or dangerously close to it. Policy makers have an understandable desire to reel that exuberance back in.
The problem is that it’s awfully difficult to take away the punch bowl after several years of non-stop partying. Central bankers have kept rates near zero since 2009 to encourage people to borrow and spend. Now they’re left to deal with what they’ve wrought.
Consider it a case of unintended consequences. Since the 1980s, policy makers have relied on monetary policy—that is, moving interest rates up or down—as the all-purpose, go-to medicine for underperforming economies. Monetary policy was thought to be inherently superior to fiscal policy—that is, spending more government money—for a couple of reasons.
One was speed. A shift in interest rates exerts an immediate effect on business and consumers while new spending programs can take a year or two to roll out.
Better yet, monetary policy is even-handed. It gets into all the nooks and crannies of the economy and affects everyone. In contrast, fiscal policy is often designed to benefit industries or regions that are particularly important to the party in power.
But as genuine as those advantages to monetary policy are, nobody ever expected a period like the one we’ve just experienced, when central banks would chop rates to near zero and keep them there, not just for a few quarters, but year after year. The heavy reliance on extended and extreme monetary therapy has left central bankers grappling with two big issues.
One, as mentioned, is frothy asset prices. As interest rates fell and it became easier to borrow, home prices surged in many countries and so did the values of stocks and bonds. That’s all very good in a crisis, when stimulus is needed, but the danger comes now, when the global economy has struggled back to its feet.
As rates start to go up, rising borrowing costs and higher payoffs on safe investments will peel back the support provided by yesterday’s low rates and act as a drag on asset prices. If monetary authorities misjudge the speed of the recovery and raise rates too fast, they could kneecap asset prices and bring markets crashing down.
This is dangerous because of a related issue: the explosion in the sheer amount of debt carried by households and companies. Low rates have encouraged massive borrowing over the past few years. This makes the global economy more fragile. Households that can easily shoulder their loans during decent times may find themselves in trouble when the next downturn hits.
The danger is particularly large in countries, such as Canada, where much of the new borrowing has gone to finance real estate speculation rather than investment in productive assets. Homes don’t generate new revenues or additional streams of income to pay for themselves so, whenever a recession hits, homeowners will be left holding masses of debt without any corresponding increase in income to service it (see adjacent chart).
What does this mean for central bankers? To my mind, there’s an understandable case for nudging up rates to let some of the air out of overinflated asset prices, but there’s also an overwhelming argument for moving with extreme caution to avoid triggering a new downturn. My bet is that today’s eagerness for raising rates will soon fade as central bankers decide to play it safe. Look for rates to rise at only a glacial pace.
Ian McGugan is an award-winning business journalist in Toronto and the founding editor of MoneySense magazine. E-mail: firstname.lastname@example.org.
Photography by Chris Helgren/Reuters