The View by Dimitris Valatsas
The lessons of the ‘Great Bond Massacre’ of 1994 show how policy decisions made in the United States can have ripple effects around the world
US policymakers have the option of expansionary policy as part of their duty to look after their constituents, but its effects are not always benign
Published in South China Morning Post on March 29, 2021
US President Joe Biden meets with Treasury Secretary Janet Yellen in the Oval Office at the White House in Washington on January 29. Photo: Reuters
US economic policy decisions have always had ramifications well beyond the country’s borders, and this year promises to be no exception. In 1971, US Treasury Secretary John Connally famously told a group of European finance ministers: “The dollar may be our currency, but it is your problem.”
Current Treasury Secretary Janet Yellen might be a more nuanced policymaker, but the central message still holds. The US makes its own fiscal and monetary policy, and it is quickly becoming the world’s problem. A contractionary global rate cycle is under way and global central banks need to act against this.
The American Rescue Plan Act signed into law by US President Joe Biden this month is projected to cost US$1.9 trillion, or roughly 9 per cent of US GDP, and it will be funded by new Treasury debt. This extra bond issuance, coupled with expectations of higher inflation and growth, has driven up government borrowing rates. Since the Georgia special election on January 4 delivered a Democratic majority in the Senate, the yield on 10-year government bonds has almost doubled from 0.9 per cent to 1.66 per cent.
But in financial markets, what happens in America does not stay in America. Developed economies have seen strong sell-offs in their domestic funding markets. Emerging markets have seen domestic rates rise even more. The effect has been less pronounced among euro zone members, who have seen their borrowing costs increase by 0.1 per cent to 0.35 per cent since the beginning of the year.
New Zealand is a prime example. Mostly coronavirus-free, its economy has run smoothly since the incumbent government was re-elected last October. It borrows in its own currency, and only about 10 per cent of its trade is with the United States. It has not passed a massive stimulus bill and inflation expectations have not changed materially. Yet, since January, its 10-year government borrowing costs have risen almost as much as the US Treasury’s, from 1 per cent to 1.7 per cent in March.
This is not the first time we have been there. In the “Great Bond Massacre” of 1994, Alan Greenspan’s Federal Reserve surprised markets by raising short-term rates from 3 per cent to 3.25 per cent. Ten-year government bonds started selling off and the government’s cost of borrowing rose as a result, from 5.6 per cent at the end of January to 7.5 per cent in May and reaching a high of 8 per cent in November that year.
Across the Atlantic, something remarkable happened. Alarmed that higher rates would endanger economic growth at a critical point for German reunification, the Bundesbank progressively lowered its discount rate.
Easier monetary policy was meant to lead to lower rates, but the opposite happened. Deutsche mark-denominated, German borrowing rates kept rising, following the Fed rather than the Bundesbank’s monetary policy. Not until the Fed stopped raising rates in 1995 did German borrowing costs decline.
Germany was not alone in this predicament. Long-term rates also rose in other countries. It did not matter that these countries had their own currencies, central banks and economic policy mix; their bond markets followed US monetary policy, and US monetary policy followed the US business cycle.
We are in a similar situation today. A strong US macroeconomic outlook is lifting global rates, even for countries that have not yet emerged from lockdowns. For those economies, the global rates cycle can have catastrophic consequences, smothering a nascent recovery before it can take root.
What can countries do to protect their economies? The experience of the early 1990s suggests that conventional responses, such as cutting short-term interest rates, will not work. Today, we are seeing that even free-floating currencies are no defence against the global rates cycle.
The answer might lie in a little-used tool of monetary policy called yield curve control (YCC), which is now deployed at scale by the Bank of Japan and to a lesser extent by the Reserve Bank of Australia. Under YCC, the central bank promises to buy enough of its government’s treasuries to keep long-term government yields at a certain level.
In today’s environment, the Japanese approach has been among the most effective in keeping the government’s rates pinned across all maturities. This is especially important for the Japanese government, whose high debt levels mean it cannot afford to pay higher interest rates.
European Central Bank (ECB) President Christine Lagarde has taken a softer approach, promising to purchase more bonds to prevent yields from rising further, but she gave no indication of the size of the bonds or the rates the ECB is targeting. The result has been a slight tightening of financial conditions – not to the same extent as in other developed markets, but not as benign as Japan either.
For a continent still in the throes of lockdowns and persistent Covid-19 cases, this is a risky approach. Explicit yield curve control would be more successful in aiding the recovery and helping governments deal with the Covid-19 debt overhang. The ECB should implement it without delay.
Expansionary policy of the type that is taking place in the United States is a choice for American policymakers who have a duty to look after their constituents first and foremost, but the ramifications are global and not always benign. Non-US central banks should act as explicitly as they can to protect their economies from the global rates cycle.
Dimitris Valatsas is the chief economist at Greenmantle