World's rising interest rates boost risks

Inflation is a usual target of central bankers, but globalization complicates their work.

When Ben Bernanke and other Federal Reserve policymakers meet this week, they'll come armed not just with their own inflation-fighting resolve but with the backing of their peers around the world.

From Britain and continental Europe to rising giants such as China and India, central bankers are marching in lock step and speaking from a common script. Inflation is their enemy, and they don't plan to lose.

On the face of it, there's nothing unusual about a tightening of money supply simultaneously in many nations. But this time around, the trend symbolizes the increasingly global terrain that policymakers must navigate.

By working together, they hope to nip inflationary pressures and wring out excesses from a world economy that is now in its fourth straight year of 4 or 5 percent growth. If they succeed, that expansion could continue apace.

But by working together, the risk of a policy misstep – tapping the brakes too hard – is also magnified. Stock markets, down globally over the past six weeks, have clearly signaled that worry.

"I think that's why we see the global response in the equity markets," says Michael Cosgrove, who writes The Econoclast, a capital-markets newsletter based in Dallas. "We have the three major central banks in the process of tightening at the same time."

The job of central bankers has always been a tricky balancing act. Open the money spigot too far and the result could be artificial growth in the form of spiraling prices – inflation. Tighten the spigot too much and economies shrink, which could lead to falling prices – deflation. A key question now is how globalization has affected growth and whether that dynamic is changing.

"The globalization of financial markets has direct implications for central banks," Sandra Pianalto, president of the Federal Reserve Bank of Cleveland, said this spring. As the forces of supply and demand become more global, it "will tie interest rates in any single country more closely to interest rates across the globe."

Many economists believe that globalization has generally been disinflationary so far. In other words, the rising flows of money, workers, goods, and services across borders have restrained the pace of price increases. For example: Hordes of workers in emerging economies have entered the global labor force, creating competition for jobs. That, in turn, has put pressure on companies in the United States and the rest of the developed world to boost productivity and offer smaller pay raises.

Now, however, these forces have largely played themselves out, some economists say. Robust global growth has driven up demand for basic commodities, from oil to copper, whose prices are now rippling into consumer products.

"The effects of globalization on domestic inflation need not ... be negative, especially in today's environment of strong global growth," Donald Kohn, a Federal Reserve governor, warned in a speech last week.

That's one reason central bankers have changed tack. For several years they've kept interest rates low to stimulate economic growth. Now, they're seeing an uptick in inflation, notably in the US and China. A host of central banks raised interest rates in sync this month. Even the Bank of Japan, after declaring victory in a long battle with deflation (falling prices), has started to tighten policy, although it hasn't raised its interest rate yet. That could come in July. The European Central Bank has also warned that it sees prices rising faster than its 2 percent target for 2007 and 2008.

"During the fastest three-year period of growth for a generation, monetary policy around the world may simply have become too accommodative," Mervyn King, governor of the Bank of England, said recently. "That monetary stimulus is now being withdrawn."

Equally important, expectations of inflation have also been rising in some quarters. Such expectations can become self-fulfilling prophecies if they prompt businesses to raise prices and workers to push harder for wage hikes. The mood shift stems from an extended rise in energy costs, but also partly from a transition in leadership at the Federal Reserve. After comments perceived by some as "dovish," Fed Chairman Ben Bernanke is under pressure to prove his anti-inflation zeal.

Still, by some measures, inflation hardly appears to be on a rampage.

Gold, often seen as a safe haven when consumer price indexes are rising, has fallen about 20 percent in price since May 11. And bond prices don't have a large built-in premium for future inflation.

"Inflation rates remain low globally," says Dr. Cosgrove, the economist in Dallas.

But central banks don't want to take chances. As money supply tightens, one result could be a squeeze on the prices of assets, from real estate to emerging-market stocks, that have risen sharply during the easy-money era. Since early May, stock prices are down 5 to 10 percent in developed nations; they're down 20 percent or so in many emerging markets. US home prices are no longer rising at double-digit rates.

Few economists spy recession on the horizon. But as policymakers try to downshift into "neutral," the danger of tightening too far grows.

"I think the risk of an adverse financial event ... is greater than 50 percent," Cosgrove says. What might that be? One possibility is a large hedge fund collapsing under the weight of bad investments made with borrowed money. That might not be a big deal for global markets, unless it rippled outward to affect large commercial banks.

Another risk is that US consumers provide less thrust to the world economy. As rising interest rates crimp the spending power of US shoppers – such as by boosting their mortgage payments and stunting the value of their homes – the result could be felt worldwide.

That's the top danger currently, says Jay Bryson, a global economist at Wachovia Corp., a banking firm in Charlotte, N.C. Still, he doesn't foresee a major economic slowdown. Wachovia's forecast is for US growth to slip from 3.4 percent this year to 2.7 percent in 2007. World GDP growth may slow from above 4 percent this year to slightly below 4 percent next year, Dr. Bryson says.

"What markets may be doing is more ration-ally repricing risk," rather than predicting a downturn, he says.

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