Most early business cycle indicators suggest that the global economy is pretty much roaring ahead. Production and employment are rising. Firms keep investing and show decent profits. International trade is expanding. Credit is easy to obtain. Stock prices keep moving up to ever higher levels. All seems to be well. Or does it?
Unfortunately, the economic upswing shows the devil’s footprints: central banks have set it in motion with their extremely low, and in some countries even negative, interest rate policy and rampant monetary expansion.
Artificially depressed borrowing costs are fueling a “boom.” Consumer loans are as cheap as ever before, seducing people to spend increasingly beyond their means. Low interest rates push down companies’ cost of capital, encouraging additional, and in particular risky investments – they would not have entered into under “normal” interest rate conditions. Financially strained borrowers – in particular states and banks – can refinance their maturing debt load at extremely low interest rates and even take on new debt easily.
By no means less important is the fact that central banks have effectively spread a “safety net” under financial markets: Investors feel assured that monetary authorities will, in case things turning sour, step in and fend off any crisis. The central banks’ safety net has lowered investors’ risk concern. Investors are willing to lend even to borrowers with relatively poor financial strength. Furthermore, it has suppressed risk premia in credit yields, having lowered firms’ cost of debt, which encourages them to run up their leverage to increase return on equity.
The boom stands and falls with persisting low interest rates. Higher interest rates make it increasingly difficult for borrowers to service their debt. If borrowers’ credit quality deteriorates, banks reign in their loan supply, putting even more pressure on struggling debtors. Also, higher interest rates cause asset prices – stock and real estate market prices in particular – to come down, putting the banking system under massive strain. In fact, higher rates have the potential to turn the boom into bust.
The US Federal Reserve (Fed), at the beginning of the 21st century,