The era of ultra-low interest rates and quantitative easing died in 2022, with the arrival of high inflation. This transformation has, for now, upended prior assumptions about markets and the economy. Central banks will no longer come to the rescue of damaged markets. As Sam Bankman-Fried of FTX has learnt, hawking speculative assets is no longer a sure road to riches. This is a new world. The question, as we go into 2023, is how long it will last.
The proximate cause of this upheaval is the unexpected surge in inflation. All important central banks, with the notable exception of the Bank of Japan, have rapidly tightened monetary policy over the past 12 months: the Federal Reserve has raised the federal funds rate by 4.25 percentage points, to a level last seen in early December 2007; the Bank of England has raised rates by 3.25 percentage points to a level last exceeded in November 2008; and the European Central Bank has raised rates by 2.5 percentage points to a level last seen in December 2008.
Bond yields have also risen. Since the end of December 2021, yields on 10-year gilts have jumped more than 2.6 percentage points, on German Bunds 2.2 percentage points and on US Treasuries 2.3 percentage points. Rates are low by longer-term standards. But US yields have not been this high since early 2011. Real rates have jumped too. Over the past year, the yield on inflation-protected 10-year US Treasuries has gone from minus 1 to more than plus 1.5 per cent.
Inevitably, higher rates have destabilised asset prices. Stock markets were notably volatile, ending the year well below peaks, though hardly cheap. Bitcoin fell from $65,000 in late 2021 to about $16,600 now. Crashes reveal what the economist JK Galbraith called the “bezzle”. This one has already revealed the ills of FTX.
The new year will be one of uncertainty. Beyond those of geopolitics and energy, the biggest doubts concern the future of inflation and monetary policy. If inflation quickly subsides, monetary policy is likely to ease in the important jurisdictions before the end of the year. If it does not, it will not. So long as this uncertainty remains, so must that over the outlook for monetary policy.
Higher interest rates will bring casualties, as debt becomes costlier. Given the uncertainty, market turmoil is also likely to continue. The combination is likely to shake out overbought assets and increase defaults. If rates rise further, defaults will become more likely. That will not just be in developing and emerging economies, where distress is already visible. Highly leveraged ventures will be under pressure in high-income countries, too. The Austrian economist Joseph Schumpeter argued that recessions caused “creative destruction”. Expensive money will at least do the needed job of reminding everybody that leverage is never a one-way bet.
A longer-term uncertainty is over whether the era of free money is going through a temporary interruption or if it is ending for good. Some, notably Charles Goodhart and Manoj Pradhan, in The Great Demographic Reversal, argue that demographic forces will mean higher inflation and higher interest rates over the long term. Against this, Olivier Blanchard, former chief economist of the IMF, insists the forces that have generated low real interest rates on safe assets go will continue to dominate, once the current inflationary shock is over.
We do not yet know who will prove right. The speed with which inflation subsides and how high real interest rates will then shape how different the future will be from the pre-inflationary past. Today, however, is a time of dearer money and risk repricing. That offers peril and opportunity.