The world’s two most important central banks signalled this week that the financial crisis is finally over. Ten years after the emergency began, the global economy has clearly returned to growth.
What’s not so clear is if the recovery can survive what happens next.
In both the United States and Europe, policy makers spent years administering unconventional stimulus measures, including rock-bottom interest rates and gigantic bond purchases, to nurse ailing economies back to health. Now that recoveries are in place, central bankers face the difficult chore of cutting back on the stimulus. It’s by no means certain they can do so without endangering their patients.
In Europe, the danger is that an uneven economic rebound will fuel a fresh outburst of political discontent. In a worst case, Italy could bolt the currency union and chaos would ensue.
For now, European Central Bank president Mario Draghi is proceeding with caution. This week, he announced that the bank was ready to wrap up its massive €2.4-trillion ($3.7-trillion) bond-buying program. The program has played a key role in keeping borrowing costs low across the continent, and its planned conclusion by the end of the year signals the euro zone is no longer in need of emergency therapy.
However, Mr. Draghi wasn’t quite ready to pack up his medicine chest just yet. To help offset the end of the bond-buying program, he indicated that the central bank’s own interest rates will remain at record lows until September, 2019. In effect, he was assuring markets he still had their backs, despite his decision to end the bond-buying program.
In Washington, this week’s message was equally nuanced.
On the tough love front, Fed chairman Jerome Powell began by hiking interest rates by a quarter percentage point while signalling two more increases are likely this year. Then, he immediately softened those moves by indicating he was in no rush to prematurely rein in the recovery, despite one of the lowest U.S. jobless rates in the past 60 years.
To help ease fears, he released forecasts that suggested the Fed is willing to let inflation run a bit above its 2-per-cent target in 2019 and 2020, rather than attempting to hammer it down with an aggressive policy of further rate hikes.
On both continents, central banks seem to be trying to convince markets that they are finally, decisively, winding down crisis-era stimulus, but only gradually – so gradually, that people will hardly notice.
In theory, this strategy should work. In practice, it will be difficult to pull off.
In the United States, Mr. Powell is leaning against the huge tax cuts engineered last year by President Donald Trump and Congress. Adding all that new stimulus to an economy already near full employment is likely to spur higher inflation.
The danger is that rising prices will force the Fed’s hand, leading to a rapid-fire series of rate hikes to cool off an overheated economy. Raise rates too rapidly and the results could be ugly. After nearly a decade of low-rate therapy, many asset prices have risen to lofty levels. A vigorous surge in rates that undermines stock and bond prices and sends mortgage rates soaring could tumble the U.S. economy back into recession.
In Europe, the problem is not so much asset prices, as politics. Germany has prospered in recent years, but Italy and several other countries haven’t. If Europe’s growth falters after the ECB’s bond-buying program wraps up, tensions across the euro zone could ratchet even higher.
So could tensions across the Atlantic. As long as the Fed persists in raising rates at a decent clip, while the euro zone keeps its rates extremely low, the disparity is likely to send the U.S. dollar higher versus the euro. That would make U.S. exports less attractive and European exports more so – an outcome that would frustrate Mr. Trump and his America First trade agenda.
Markets are displaying a decidedly cautious attitude. Large, globally important banks have sold off in recent weeks. The iShares S&P Global Financials ETF, which hold many of the biggest international lenders, is down 12 per cent since late January.
Another flashing yellow light is the 10-year U.S. Treasury bond, a haven asset that becomes more attractive as anxiety increases. The yield on the 10-year Treasury moves in the opposite direction to its price, and is one of the most reliable measures of global sentiment.
At the moment, it suggests a darkening mood. After briefly sticking its nose above the 3-per-cent level a month ago, the yield on the benchmark bond has since retreated to around 2.90 per cent.
Its decline has helped to flatten the yield curve, a measure of the difference between short-term and long-term borrowing costs. An inverted yield curve, in which short-term rates are higher than long-term rates, has historically been a strong signal of recessions ahead in the United States.
While the curve is still not inverted, it is becoming increasingly flat. On Friday, the gap between two- and 10-year Treasury yields had narrowed to less than 40 basis points (there are 100 basis points in a percentage point). The current gap is one of the flattest readings since 2007.
The flattening curve crimps banks’ ability to profitably borrow short term and lend for longer periods. It also feeds concern that the next calamity is not too far away.
To be sure, the most likely cause of that calamity isn’t monetary policy but trade wars. Mr. Trump’s announcement of US$50-billion in further tariffs on China triggered market tremors on Friday. But that just demonstrates a key point about crises in general: The moment you think you have one cured, another is getting ready to take its place.