Cracks are beginning to appear in the great wall of liquidity built by developed economies’ central banks that has so far propped up high-yielding assets like commodities and emerging-market stocks and bonds. On Thursday, the European Central Bank raised interest rates for the first time since July 2008 in response to rising inflation. If analysts are to be believed, a couple of more increases are due over the rest of the year. With inflation rates in the UK at over four per cent, the Bank of England could follow with an increase in May. However, the real market mover going forward could be the mother of all central banks, the United States Federal Reserve (Fed). US labour market data for the last few months have been nothing short of spectacular with the unemployment rate dropping from a peak of 9.7 per cent in November 2010 to 8.8 per cent in March 2011. The problem is that better employment conditions than expected suggest a sharper recovery in the real economy. This has kindled fears of a build-up in inflation in the US. Treasury bond yields, which usually serve as a barometer of inflation expectations, have hardened over the past few weeks. This implies that the Fed might have to reverse its monetary policy stance from “hyper-expansion” to slow contraction.
It is unlikely that the Fed will change course in a hurry. The American housing market, for one, looks somewhat weak. Mortgage applications in March, for instance, were close to a record low. Durable goods sales numbers have disappointed over the past few months. Besides, Fed Chairman Ben Bernanke and a number of senior Fed officials seem reluctant to abandon QE2 (or quantitative easing — the monetary stimulus programme launched in November that aims to release $600 billion into the US economy by July) midstream. However, given the improved rate of job creation and the prospect of improved growth, it is unlikely that a fresh monetary stimulus programme is likely to be announced after July. While the US’ inflation rate at 2.1 per cent is still somewhat muted, the mix of a rising business cycle, hugely surplus liquidity and elevated commodity prices could set off a sudden inflationary spiral. Thus, after July the Fed might have to consider a strategy of sucking out some of the liquidity that is sloshing around possibly through bond sales. If the spigot of dollar liquidity is turned off, it is bound to take a toll on all asset classes that rode the wave of cheap dollars. This includes Indian stocks and possibly external borrowings. Over the last couple of months, events in Japan and North Africa have distracted the markets that seem to have temporarily ignored this rising liquidity risk. The worry is that when this risk jumps back on investors’ radar screens, the corrections in the asset markets could be sudden and deep. The joker in the pack remains the Bank of Japan, which has embarked on another round of easy money policy both to aid reconstruction efforts and to keep the yen weak to aid exports. Whether loose liquidity in Japan can offset the impact of monetary contraction in Europe and the US is an issue that markets will have to grapple with over the next few months. This looks unlikely and investors perhaps need to prepare for rough times ahead.
