THERE's no doubt that the aggressive easing in monetary policy in developed countries in 2008 was unavoidable. But now that major economies are pulling out of recession and the bulls have had a lovely time in the markets, it's time to ask the question: when will leading economies, most notably the US, hike interest rates?
The answer is of far more than mere academic interest. Arguably, the timing and extent of US interest rate hikes will affect all markets. The dollar should strengthen as capital flows back to the US, leaving the rand and other similar currencies softer.
Bond markets will weaken, and bond issuers have already been doing their thing at a frenzied pace to lock in the low rates now while they last. Equity markets, too, could take a hit, depending on how tight the US wants to take monetary policy.
At present, the US Federal Reserve funds target rate (its benchmark interest rate) is at 0% to 0.25%. A Reuters poll just before Christmas found that nine out of 15 economists expected US interest rates to rise before the end of 2010. However, most believe it will be late in the year.
Trouble is, the Great Recession may be ending but its death might be protracted and a vibrant economy could take a while to rise from the ashes. However, some commentators - most notably those bulls who enjoyed last year's good run on the markets - are warning against the Fed taking too long to raise rates, and being too slow in going about it.
One reason why there is worry about the Fed waiting too long - say, until next year - is the fact that new market bubbles may be building up. Many commentators believe that too-low interest rates for too long in the past were one of the main causes of the financial crisis that brought the global economy to its knees. From 2000 to 2003, the Fed lowered its funds target rate from 6.5% to 1%.
Bernanke hits back
It held rates at what was then a record low for a year, and then followed this up with a measured (some would say too slow) rate hiking cycle from 2004 to 2006.
The key point is that, while rates were so low for such a long period in the past, the US housing market went into the stratosphere. The amazing rises in house prices engendered a belief among bankers that US house prices could never go bust. They gave out lots and lots of loans on the basis of that dangerous assumption.
However, US Fed chief Ben Bernanke recently came out with all guns blazing against the view that low interest rates were a cause of the crisis. In a recent speech, Bernanke defended the central bank's actions.
He said extra-low rates had been needed to get the economy and job creation back to full throttle after the September 11 terrorist attacks in 2001, and the accounting scandals that rocked Wall Street after the dotcom bubble burst.
Some commentators now argue that the Fed should have moved to prick the housing bubble by raising rates earlier, even if inflation was under control. But Bernanke said that rate increases in 2003 and 2004 to constrain the housing bubble could have "seriously weakened" the economy just as recovery from the 2001 recession was starting.
Bernanke said banking regulation was the way to prevent financial crises. But, crucially, he didn't rule out the use of interest rates to constrain bubbles.
Rand already bubbling
He said: "If adequate [regulatory] reforms are not made, or if they are made but prove insufficient to prevent dangerous buildups of financial risks, we must remain open to using monetary policy as a supplementary tool."
Towards the end of 2009, John Stopford, Investec Asset Management's co-head of fixed income, pointed out that the Fed has tended to wait about six months after the unemployment rate peaks before raising the Fed funds rate.
The US unemployment rate has been hovering around 10%, which looks like a peak. Stopford said at the time it seemed the Fed would start raising rates around the middle of 2010.
"We expect the move to higher rates to be relatively rapid, at least initially ... First, a neutral rate is well above current levels. Second, the Fed's gradual approach to tightening from 2004 now looks to have been a mistake, whereas the shorter, sharper rate cycle from 1994 was followed by a long period of more balanced growth."
But Stopford may be wrong about the Fed's willingness to upset the markets in the short term for gain in the medium term.
Trouble is, the very low interest rates in the US have already caused a bubble for currencies such as the rand, as speculators have borrowed in countries with official rates of below 1% and invested the currency short-term in places such as SA, with rates of 7% - making a tidy profit on the interest rate gap.
Let's hope Bernanke will see that the Fed has been complicit in the build-up of bubbles, and that it will go about pricking them with care - sooner rather than later.
- Fin24.com