Financial Times Editorial - Slow end to the days of easy money

Slow end to the days of easy money
Published: February 18 2006 02:00 | Last updated: February 18 2006 02:00. Copyright by the Financial Times

All eyes this week were on Ben Bernanke, the new chairman of the Federal Reserve, as he gave his first testimony to Congress. Mr Bernanke was mildly hawkish, but no more so than the Fed had been at its last meeting under Alan Greenspan on January 31. Still, there is broad consensus that the Fed is near the end of its rate-tightening cycle, with probably no more than one or two quarter-point increases left. The end of a tightening cycle is often the trigger for a rally in equity markets. Such celebration, however, would be premature. While the Fed is near the end, the global rate-tightening cycle is only at the half-way stage.

Japan on Friday released figures showing gross domestic product grew at an annualised rate of 5.5 per cent in the fourth quarter of 2005, making it the fastest growing big economy over that period. The contrast with the eurozone, which grew at an annualised rate of just 1.2 per cent in the fourth quarter, is stark. Japan's growth rate is certain to moderate, while the US is set for a roaring start to 2006. Still, with annual core consumer price inflation turning positive (just) in December, an end is in sight for Japan's ultra-loose monetary policy. This, alongside Japan's return to steady growth, will have global consequences.

Seen from a global perspective, rather than a national perspective, monetary authorities are mid-way through a process of normalising interest rates slashed to support growth after the dotcom bubble burst in 2000. Britain is furthest down this track, with this week's inflation report pointing to broadly steady interest rates and inflation, at about 4.5 per cent and 2 per cent respectively. The US is not far behind, with nominal rates already matching the UK and set to go higher, at least until the housing market eases decisively. Japan is approaching the starting line, with a probable reduction in quantitative easing in April foreshadowing an end to zero interest rates before the end of this year. The rate-tightening cycle in the eurozone jumped the gun, and may need to pause, but will resume in time.

In an era of global production and capital flows even investors who stick to their home markets must consider the potential effects of a narrowing global output gap and tighter global liquidity. The end to Japan's zero interest rate policy and heightened risk of yen appreciation, for instance, will undermine the "carry trade" (borrow free in yen, buy higher yielding assets elsewhere) that has helped keep risk spreads low across all asset classes.

However, there are important caveats to the normalisation story. It remains unclear how high global rates can go without causing a sharp slowdown in growth. This is a world with big imbalances adjusting to a massive labour supply shock: the integration of China into the international economy. There are structural disinflationary forces, while yield curves suggest limited scope for higher real interest rates.

Japan's return to solid growth is unquestionably good news, but does not present a simple solution to imbalances. While domestic demand is growing solidly, net exports surged again in the fourth quarter. Moreover, to the extent that China has spare capacity to supply, if Japan imports more from China it may only transfer its trade surplus, not reduce imbalances overall.

Policy normalisation, then, will proceed, with significant impact on markets. But normalisation this time may not mean a return to what we previously thought of as normal.