One swallow does not make a summer, and one month of normal job growth, and rising prices in the United States does not mean that the Federal Reserve no longer fears economic malaise and deflation. But the time will come when world interest rates begin to rise, as central bankers prepare to resist the upward creep of inflation.
Whenever that moment arrives - whether this fall, in 2005 or 2006, or in 2007 - America and the global economy will face financial vulnerabilities that reflect the success of the past three years of monetary stimulation in stemming declines in production and moderating unemployment. Short-term interest rates are astonishingly low: only 2% in the euro zone, just 1% in the US, and zero in Japan. Expansionary monetary policy has been successful, but only by pushing interest rates to historic lows - and by convincing investors that borrowing costs will remain at their current levels for a long time.
The main result of monetary stimulus has been to boost asset prices: anything that pays a yield, a dividend, or a rent becomes much more attractive - and hence much more valuable in money terms - when interest rates are very low and expected to stay very low. This explains the large gaps between current prices for real estate in the US, equities in New York, London, and Frankfurt, and long-term bonds everywhere and what one would conventionally think their fundamental values should be.
So what will happen when central banks start raising interest rates? In 1994, rising short-term rates caused increases in long-term rates - and declines in long-term bond prices - that were at least double what standard models at the time were predicting. Moreover, interest rates in the world's peripheral, developing economies rose far more than rates in the advanced industrial core.
Thus, the first danger to worry about for 2005 and beyond - when world interest rates will most likely rise - is another wave of emerging-market financial crises. For countries like Mexico, Brazil, Turkey, Argentina, Korea, Malaysia, and Thailand, the record of the 1990's demonstrates that interest-rate spreads can widen and capital flows reverse remarkably rapidly, regardless of how favorably IMF officials and analyses by major banks view a country's policies.
Emerging-market interest-rate spreads now are abnormally low. International money flows - aside from inflows into the US - are not yet at levels associated with "irrational exuberance," but there is still time for that to happen before interest rates start to rise. This is an alarming prospect, because if there is one lesson from the 1990's, it is that nobody should overestimate the stability of international financial flows.
The second danger springs from high asset values within the advanced industrial core. The dominant mode of thought within the Federal Reserve - with which I agree - appears to be that the information-technology revolution is continuing, that the pace of growth of potential output in the US remains very fast, and that the output gap is thus relatively wide. This implies that interest rates may, in fact, need to stay low for a very considerable period.
Moreover, confidence in the Federal Reserve is high, and the last remnants of the 1970's inflation risk premium have been wrung out of interest rates. As a result, even after output levels return to their potential, interest rates will stay low by the standards of the 1980's and the 1990's.
All of this is, of course, good news for those who own assets like long-term bonds, stocks, and real estate. Indeed, elevating long-term asset prices was precisely the point of lowering interest rates: making bondholders and especially real estate owners richer, after all, provides a fillip to spending.
But the bad news is that even if interest rates are expected to remain low for a while, they will not stay this low indefinitely. The bottom line is that when interest rates rise, asset values will fall. It is during such periods - particularly when asset values fall swiftly and substantially - that we discover exactly how good our central bankers are at their main job: reducing financial volatility and promoting economic stability.
It is also during such periods that we discover how many people who are holding long-term bonds, real estate, or stocks are doing so not because they think current prices are attractive relative to fundamentals, but because their prices have gone up over the past several years. This is a crucial question for policy makers, because those who bought long-term assets due to what seemed like perpetually rising prices are also those who will sell as soon as price trends seem to be reversing. In particular, the US trade deficit looms as a massive source of instability should long-term asset prices fall significantly.
To be sure, the challenges facing the world's economic policy makers during the next several years will be different from those that they have faced since the collapse of the NASDAQ bubble. The risks associated with inflation are probably less dangerous than those generated by collapsing output and the threat of deflation. But, as we learned in the 1990's, this does not mean that the coming challenges will be easier to handle.