Accident Zone

Rising global interest rates and the world’s five biggest central banks tightening money supply have created the environment in which, over the past 16 years, there have been a series of global financial crises.

ANZ chief economist Saul Eslake says that by mid-May, against a backdrop of rising rates, markets suddenly became less complacent about risk, and that the re-evaluation of risk is continuing.

The new climate means economists and investors are looking much more closely at every new piece of financial data and considering the consequences. As he says: “Potentially we are in precisely the circumstances when a financial accident could happen. It’s in the nature of financial accidents, unfortunately for forecasters, that you don’t know when they’re going to happen.”

The interview

Alan Kohler: The markets are obviously reacting to the prospect of rising interest rates '¦ I suppose the fact of rising interest rates '¦ but I don’t really understand this because it’s no surprise that rates are going up and in fact it seems that we’re heading towards the end of the tightening cycle. So what’s going on?

Saul Eslake: I think there are two things about that. First of all, interest rates are now going up almost everywhere, whereas for most of the past two years they’ve only been going up in the United States. So although money has been getting more expensive in the US there’s still been plenty of cheap money available from almost anywhere else in the world, particularly Japan. Even in Japan where rates are yet to go up, it’s clear that within the next three months they’ll start going up even there too. The second thing is that there is now a lot of uncertainty about when and by how much US rates will rise further. For most of the past two years, ever since Alan Greenspan began the process of returning US interest rates to normal, it’s been London to a brick that at the next meeting of the Federal Reserve rates would go up by a quarter of a percentage point, and that the one after that they’d go up by a quarter of a percentage point, until they got back to some level of normality, which people knew was somewhere between 4.5% and 5%.

It’s London to a brick again that rates are going up later on in June, isn’t it?

It is now but it wasn’t four weeks ago when Ben Bernanke tried to signal to the markets that there was a chance that the Fed could pause even if inflation was going to be temporarily above their presumed target range. The problem now is that no one knows for sure whether rates are going to go up beyond June and if so by how much. What that in turn means is that for the first time really since about 2002, if not earlier, every piece of economic data potentially has a bearing on the probability of whether rates will rise more than once and if so, how high they will go. Prior to this it didn’t matter whether each piece of data said the economy was growing fast or slow or whether inflation was rising or falling '” you knew the Fed was going to put rates up. Now that rates are starting to get to levels where they might adversely impact the US economy it does matter whether each piece of data shows inflation rising or falling or the economy growing strongly or slowing.

What’s this doing to the perception and the pricing of risk?

What it’s doing belatedly, I would say, is making markets much more circumspect about taking on additional risk. In some ways, as you say, it’s been obvious for a long time that rates are going up not only in the US but elsewhere and yet until about mid-May of this year markets had been remarkably complacent in pricing for risk. All the market-based measures of investor appetite for risk had been at record highs '” be it the level of volatility on US stock price index futures or the spreads between risky fixed-income products like emerging market or corporate bond debt over risk-free products like US Treasury bonds had been at record lows and it was hard to figure out why, from an objective observer’s position, markets were so blase about the change in the risk environment. I guess markets do tend to move in jerky ways rather than in smooth continuous ways and while you can’t pinpoint what triggered this re-evaluation of the risk outlook, there’s certainly a significant re-evaluation now going on.

Is that all that’s happening? That markets are becoming less blase?

Yes in some ways I think that’s a big part of it, but there could still be more to come because we don’t know how far this tightening process is going. What we do know, although I still don’t think sufficient regard is being paid to it, is that globally we are in a phase of the business or monetary policy cycle when financial accidents tend to happen. When central banks raise interest rates as they’re now doing all over the world, they don’t simply pass a law that says rates are now higher than they used to be, they actually deal in the financial markets to push interest rates up. They’re pushing rates up by, for the most part, selling government securities or other paper that sucks up money. What you now see when you look at the measures of money supply that are under the direct control of the world’s five biggest central banks they’re actually declining and historically the world’s major financial accidents in the past 16 years '” the Savings & Loan crisis of 1989 in the US; the Mexican debt crisis of 1994; the Asian financial crisis of 1997-98; the Russian bond and hedge fund crisis of 1998; and the tech wreck itself '” all happened during periods such as the one we’re now in, when the money supply under the direct control of the world’s leading central banks has been contracting.

There is a lot to worry about, isn’t there, potentially?

Potentially we are in precisely the circumstances when a financial accident could happen. It’s in the nature of financial accidents, unfortunately for forecasters, that you don’t know when they’re going to happen. You don’t know where they’re going to happen and you don’t know what’s going to precipitate them. Otherwise if you did, these accidents would have all been foreseen (and of course we know that they weren’t), so investors are right to be highly attuned to the possibility that a financial accident could happen somewhere in the world at some point over the past six months. My own guess is that there is a bit more price action to happen before those risks are fully factored in.

Obviously interest rates are responding to rising inflation and they’ll stop going up if it’s clear that the economy is slowing. So can you just tell us briefly what is going on with inflation and the economy?

Well in the US, which is most advanced in this process, inflation is clearly rising. The headline level is rising by almost 5%, although a fair bit of that in the US is the result of increased petrol prices, which tend to be discounted in focusing on the core inflation rate. But the core inflation rate is also rising at about 2.5% per annum now, and while that might be acceptable in Australia in the US, where the Fed’s implicit target is an inflation rate of 2%, it is, as Ben Bernanke has been saying, uncomfortably high.

In that sense the Fed’s got a problem but because inflation tends to lag the business cycle they also have to be careful that in responding to that uncomfortably high inflation rate they don’t raise rates to the point that kills the economy and throws it back into recession again. The economy is certainly slowing from the very rapid pace that we saw in the first quarter when growth was at an annual pace of over 5%. It’s not clear that it’s slowing, say to less than 3%, but another thing that I think is important in the US context is growing evidence that the US housing market is reaching a plateau.

Now we know here in Australia, and the British know from their experience, that when the housing market reaches a plateau even if it doesn’t crash, even if prices don’t fall, the fact that house prices stop rising induces a significant change in consumer behaviour. Consumers stop borrowing against capital gains on their houses that are no longer occurring in order to spend more than they earn on other consumer goods and services. That was the main reason why Britain’s economy slowed to the point where, last August, the Bank of England cut rates and if it wasn’t for the impact that China is having on the Australian economy then we probably wouldn’t have had the rate rise we had in May either. The US is starting to enter a period, I think, similar to the one that Britain has been in for the last year and the Fed needs to be careful in these contexts that they don’t raise rates to a level that causes house prices to fall.