Suddenly, after years of ultralow interest rates, central bankers are signalling they're ready to start hiking borrowing costs.
Bank of Canada Governor Stephen Poloz surprised markets this week by hinting at higher rates ahead. Nearly simultaneously, European Central Bank chief Mario Draghi, Bank of England boss Mark Carney and Federal Reserve chair Janet Yellen spouted similar, hawkish sentiments in what could be interpreted as a co-ordinated global effort to reshape expectations.
The tough new tone among central bankers is an important shift and markets reacted violently. But bankers' fresh willingness to contemplate higher rates is also, by conventional reckoning, a mystery.
Central banks normally boost rates to put a lid on rising inflation. These days, however, you have to squint awfully hard to detect any signs of price pressure in developed economies. In Canada, the consumer price index is inching upward at a mere 1.3 per cent a year, while comparable figures in the United States and the euro zone are below 2 per cent.
Given this near-complete lack of any inflationary excess, what could be prompting central bankers to abruptly rediscover that there's an "up" button on the interest-rate control panel?
It may well be concern about sky-high asset prices.
Canadian home prices, U.S. stock prices and European bond prices have all ascended to stratospheric altitudes in recent years, breeding social inequality and creating the risk of disruption if anything goes wrong. A measured dose of higher interest rates could help restrain those elevated asset prices and slowly return them to more sensible levels.
To be sure, central bankers are unlikely to explain the process quite so bluntly. It would be considered uncouth – and politically explosive – for the custodians of the financial system to announce they intend to start putting pressure on the value of people's investments. But one unavoidable side effect of raising rates is just that – a downward drag on asset prices.
Monetary policy works in large part by influencing the value of assets such as stocks, bonds and real estate. When times turn tough, for instance, central banks respond by cutting interest rates. As rates fall, it takes more cash on hand to guarantee a given amount of payout down the road, so the value of any future payout goes up in terms of what it is worth today.
This means that the present value of stocks, bonds or real estate also go up, because they generate those future payouts. Higher asset prices then spur economic growth by making people feel wealthier and by giving folks more reason to go to work and create more of all the things that are rising in value.
Yes, it's a complicated process. But you'll recall that this sequence – low rates, rising asset prices, economic stimulus – is exactly what occurred after central banks slashed rates following the financial crisis. As the economy begins to return to normality, it's natural for the process to go into reverse, in order to remove unneeded stimulus.
There's nothing particularly controversial about any of this – unless, that is, you happen to be heavily invested in the assets that are most affected. Back in the fall of 2011, in its Quarterly Bulletin, the Bank of England published a handy guide to quantitative easing, much of which applies to any easy-money program. It includes a helpful graph that shows real asset prices surging during the first phase of loose money – and then quickly plunging back to earth as policy tightens.
What has been surprising this time around is how long the easy money has lasted. Back in 2013, Harvard economist Jeremy Stein, then a governor of the U.S. Federal Reserve, cautioned that a prolonged patch of low interest rates creates worrisome incentives for people to take on greater risk in a reach for yield. But four years later low rates are still with us.
Judging by central bankers' new tone in recent days, that may be about to change. A move to higher rates can be interpreted as good news, a declaration that the global economy has recovered to the point where more normal rates are appropriate. But it can also be taken as a sign of worry over potential bubbles in asset prices.
For investors, the one sure prediction is that volatility will increase. Despite the Bank of England graph, it's not absolutely necessary for asset prices to plunge as easy money policies turn tighter. It all depends on exactly how fast rates go up and how the real economy responds.
People have every right to be nervous about how central banks will manage this process. Unwinding years of ultralow interest rates is a precarious balancing act. If you thought Thursday was a wild day in the markets, brace yourself. The fun has just begun.