The Resurgence of Monetary Tightening

Why So Many Central Banks are Raising Interest Rates

The Resurgence of Monetary Tightening
September 5, 2014

The Federal Reserve has been steadfast in its stimulus policy in recent months, refusing to conclude that the economy is improving at a sufficient level to raise interest rates. The Eurozone has kept a similarly loose monetary policy, with the European Central Bank (ECB) going so far as to introduce a negative interest rate in June. However, with good economic news outweighing the bad in recent times, expectations are increasing that the Fed will raise interest rates sooner than the expected target of 2015.

Meanwhile, there are an increasing number of central banks that are raising their interest rates – potentially a third of central banks, according to a July Bloomberg report based on information from Ned Davis Research. Why is this the case? Generally, the reason is currency devaluation, either to halt or pre-empt it.

As central banks raise interest rates to combat inflation, the money supply tightens. With a smaller amount of a nation’s currency on the market, its value rises (as with anything where demand outstrips supply). The Bloomberg report highlighted six nations that raised their interest rates in the April-June time period – Brazil, New Zealand, Russia, India, South Africa, and Colombia – and their corresponding increases in the value of their currencies ranging from 0.5% to 4.9%.

Before jumping on trends of tighter worldwide monetary policy, one should note that, in every month this year but April, there were more banks cutting rates than raising them, according to the Central Bank News. July was unusually volatile, with 23 central banks introducing rate changes (10 raising rates and 13 cutting them). So far, August has been a relatively uneventful draw, with Romania cutting rates and Gambia raising them. (News flash to the “multitudes” of investors with heavy exposure to the Gambian bond market: you just lost money!)

Global unrest is another significant driver of monetary tightening, having triggered the July increases in Ukraine and Russia. With unrest in the former caused by the latter and sanctions increasing as a result, Russia raised its rate for the third time in 2014 to prop up the ruble.

In their June annual report, the Bank for International Settlements (BIS) criticized the recent monetary trend of central banks raising rates more gradually and slowly than the rate in which they are originally cut (in reaction to shorter-term business cycles). BIS contends that a disconnect has been created as a result while investors search for better yields (much as with the overvaluation of stocks).

In addition, the BIS claims, the effect of abnormally low rates for extended times has “created a debt trap” – fueling debt-driven economies and making it difficult for central banks to raise rates without causing subsequent economic harm. BIS may have a point – according to their report, debt-to-GDP ratios are 175% in emerging economies and an worrisome 275% in advanced economies – but political pressures within countries make this philosophy unlikely to change, at least in the near term.

In short, more of the large central banks are beginning to raise rates – either to deal with real inflation or perceived/forecasted inflation, as well as to prop up weak currencies. However, collective central bank actions are a mixed bag for the moment. When the Fed finally does raise rates, whether it is in 2014 or 2015, will central bank activity worldwide follow suit? The guessing game should make for some interesting currency markets over the next year.

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