Markets & Stocks
A global tightening
As central banks head into tightening mode, the world economy will face some tough hurdles.
December 11, 2003: 12:00 PM EST
By Justin Lahart, CNN/Money Senior Writer

NEW YORK (CNN/Money) - With economies all over the world on the rebound, the Fed isn't the only central bank that will consider tightening up in the year to come.

Rather, it looks as though a push toward higher rates will be a global phenomenon.

Unexpected strength out of the euro-area economies, along with worries over the fiscal profligacy of some governments, has set many forecasters penciling in rate hikes from the European Central Bank by next spring.

The People's Bank of China is clearly worried the Chinese economy is overheating. In Britain, worries over rising housing prices and household debt levels prompted the Bank of England to up its overnight rate last month. Australia, also worried over household credit, has raised rates twice.

And the Fed? After it dropped the deflation alert at its meeting Tuesday, futures market participants are now pricing in a quarter point hike in the fed funds rate by May.

Of the major world economies, only Japan looks unlikely to see higher rates next year -- although a rising yen, because it hampers economic growth, acts like a rate increase anyway.

There have been other times when banks around the world have gone into tightening mode, points out Morgan Stanley chief economist Steve Roach. The important difference this time around is that rather than trying to cool the global economy off, they're mostly just trying to bring rates back to something like normal.

"We have central banks that are trying to frame exit strategies from unusually accommodative conditions," said Roach.

The health of the global economy will depend deeply on how effective they are in accomplishing that.

Walking a tightrope

It's going to be a hard trick turn. If, for instance, China were to slam on the brakes too hard, that would be bad news for Japan and other Asian economies which have become increasingly dependent on the mainland for growth. In response to a slowdown at home, the region could try to export its way to health, putting heavy pricing pressures on U.S. and European businesses.

An even greater worry is that businesses and consumers around the world have become overly dependent on low rates. Financial institutions have been heavy in carry trades, where they profit by borrowing at low short-term rates and lending at higher long-term rates. Many consumers are carrying heavy debt loads.

Because the world economy is so levered to low rates, even incremental central bank rate increases could carry a powerful wallop.

Europe looks as though it's in the best condition to weather rate hikes, according to Carlos Asilis, portfolio manager at the hedge fund Vega Asset Management. Savings rates are high, lower energy prices (in euro terms) are giving European economies a boost, and there appears to be substantial pent-up demand in both the consumer and business sectors.

The U.S. outlook is more worrisome. The rise in mortgage lending rates has already put the pinch on some banks, as Washington Mutual indicated when it warned on earnings Tuesday. If the yield curve -- the difference between short-term and long-term rates -- were to flatten significantly, "it would be horrific for financials," said Asilis.

Meantime, U.S. consumers are heavily in hock. Neither consumer debt as a percentage of personal income nor household debt as a percentage of personal assets has ever been as high. Some observers reckon the debt problem is so bad that the Fed simply won't be able to bump up rates.

"There is too much debt," said SoGen Funds manager Jean-Marie Eveillard. "Imagine the people who bought a house with nothing down and have a variable rate mortgage. What will happen to them if rates go up sharply, or even moderately?"

Interest Rates
Central Banks
Federal Reserve
Written by: Justin Lahart

The problem is that although the Fed has influence over long-term rates, the bond market maintains ultimate control. If the bond market believes the Fed is behind the curve, and that as a result the risk of inflation has risen, it will demand much higher long-term rates.

If the Fed keeps rates low while the rest of the world tightens, unfortunately, investors could retreat from Treasurys, sending yields, and hence mortgage rates, higher.

"Policy makers are doing their best to try and convince market participants that there is a benign resolution to all our problems," said Roach. "That may not be the case."  Top of page

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