The Economist - UK (2022-05-07)

14 Leaders TheEconomistMay7th 2022

A

s central banksdo  battlewiththeworstinflationfora

generation, they are putting the easy­moneypoliciesofthe

past  decade  into  reverse.  This  week  the  FederalReserveraised

interest rates by half a percentage point and announcedthatit

would  soon  shrink  its  portfolio  of  bond  holdings.TheBankof

Australia, which not long ago was predicting it wouldkeeprates

near zero until 2024, surprised investors by increasingthemon

May 3rd by a quarter­point. As we published ourweeklyedition

the Bank of England was expected to raise rates totheirhighest

level since 2009.

Though share prices jumped after the Fed’s raterise—inap­

parent  relief  that  it  is  not  tightening  faster—financialmarkets

have  been  adjusting  painfully  to  the  reality  oftightermoney.

Global stockmarkets fell by 8% in April and are

down by 11% in 2022, as investors price in high­

er rates and lower growth. On May 2nd Ameri­

ca’s  ten­year  Treasury  yield,  which  moves  in­

versely to prices, briefly hit 3% (see chart), near­

ly double its level at the start of the year.

One  consequence  of  tightening  financial

conditions is a repricing of currencies. The dol­

lar is up by 7% against a basket of currencies ov­

er  the  past  year.  America  needs  higher  interest  rates  than  any

other big rich country, because of its overheating economy and

labour market. Higher rates in America increase investors’ appe­

tite for dollars, adding to dollar­demand caused by a fall in their

desire to take risk elsewhere as war rages in Ukraine and China

battles the coronavirus. Most striking has been the greenback’s

appreciation against the Japanese yen, the only currency of a big

rich country in which interest rates look unlikely to rise soon. In

real terms the yen is at its cheapest since the 1970s.

Another  result  is  the  growth  in  risk  premiums  as  investors

worry about pitfalls in the new economic landscape. In America

measures of the “inflation risk premium”, which goes up when

prices  become  difficult  to  forecast,  are  at  their  highest  since

1994.LiquidityintheTreasurymarketappearstobethinning

(seeFinance&economicssection).Thespreadonmortgage­

backedsecuritiesoverten­yearTreasurieshasdoubledsincethe

startoftheyear,reflectingworriesthattheFedcouldactively

sellitsmortgagebonds.Therehasbeena modestincreaseincor­

porate­creditspreads asinvestors weighthe possibility that

higherrateswillmakeitharderforcompaniestoservicetheir

debts.AndinEuropethedifferencebetweenwhattheGerman

andItaliangovernmentsmustpaytoborrowfortenyearshas

risenbecauseofthedangerthattightermonetarypolicymakes

it harderforItalytocopewithitstoweringdebts.

Athirdeffectisthepoorperformanceofevendiversifiedin­

vestmentportfolios.InAmericainvesting60%instocksand

40%inbondsproducedanannualaveragere­

turnof11%from 2008 to2021,buthaslost10%

thisyear.Whereas 2021 markedtheapexofthe

“everythingrally”inwhichmostassetprices

rose, 2022 couldmarkthestartofan“every­

thingslump”,withtheendoflowratesmade

possiblebylowinflation—themacroeconomic

foundationofhighinvestmentreturns.

As investors suffer, monetary policymakers

may be tempted to change course. If they stopped raising rates

and  let  inflation  run  hot,  bondholders  would  lose  money  but

more  inflation­proof  assets,  such  as  stocks  and  houses,  would

benefit. The dollar would fall, helping the many countries which

denominate some of their exports or debts in dollars.

Yet  it  is  the  duty  of  central  banks,  including  the  Fed,  to  re­

spond to the economy at home and to stop inflation persisting at

an intolerable level. Tighter financial conditions are the natural

consequence of raising rates, and the adjustment has some way

to go. Investors are still betting that America’s interest rates will

peak at a little over 3%. That is unlikely to be high enough to rein

in underlying inflation, which has risenabove 5% on the Fed’s

preferred measure. More pain lies ahead.n

Tighter monetarypolicywillsqueezeglobalfinancialmarkets

US, ten-year Treasury yield

%

3

2

1

0

2020 21 22

The rate fate that awaits

Inflation, bonds and stocks

T

he united states maintains hundreds of military bases in

at  least  45  countries.  Britain  runs  plenty  of  outposts  over­

seas. French forces are stationed from Ivory Coast to New Cale­

donia. Even tiny Singapore has training camps abroad. But five

years after it opened—to the alarm of Western officials—China’s

naval  base  in  Djibouti,  on  the  Horn  of  Africa,  remains  its  only

military bastion beyond its borders.

China wants to change that. Over the past two decades it has

amassed  more  ships  than  America’s  navy  has  in  total.  Lately  it

has  increased  efforts  to  find  foreign  berths  for  them.  It  is

thought  to  have  approached  at  least  five  potential  host  coun­

tries. A deal with the Solomon Islands, signed in April, has raised

fears that China may establish a military foothold there (see Chi­

na section). And it has deepened concerns that, one day, China

will challenge American naval dominance in the Pacific.

China calls America “imperialist” for keeping foreign bases,

while  insisting  that  its  own  military  expansion  is  peaceful,

nothing to worry about and only natural for a rising power. It is

surrounded  by  unfriendly  island  chains  and  narrow  straits.

Most  of  its  trade  in  goods  moves  by  sea.  It  is  only  prudent  for

China  to  seek  friendly  ports  abroad,  its  officials  say.  It  needs  a

navy  equal  to  the  task  of  defending  its  overseas  investments,

How America and its allies should respond to China’s search for foreign outposts

Cover your bases

China and the world