The Coming Age of Interest

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.