Markets have fallen because the era of free money is coming to an end

After the interest rate cuts and frantic central bank bond buying at the start of 2020, investors came to believe that central bank stimulus would pretty much last forever.

Today, however, as investors come to terms with the end of the era of free money, financial markets are in spasm.

Markets now expect interest rates to rise four times in 2022 as the US Federal Reserve battles inflation that has taken consumer price index growth to 7%, a level barely imaginable a year ago.

On January 26, the Fed confirmed that it would end its bond buying program and signaled that it would likely raise rates soon.

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This hawkish shift is the most significant of many to have taken place in central banks around the world in recent months. But it has only recently begun to bite into asset markets.

After hitting a staggering high of almost 40 times earnings at the start of the year, the S&P 500 index of stocks fell 9% in January (markets in Europe and Asia also fell, but in a lesser extent).

Inflation in Europe hit a record high, while in the US it hit 7%, a level barely imaginable a year ago.

Olivier Matthys/AP

Inflation in Europe hit a record high, while in the US it hit 7%, a level barely imaginable a year ago.

Intraday market volatility was equally striking, reflecting investors’ difficulty in digesting the consequences of monetary tightening.

One is the revaluation of long-lived assets. As interest rates crashed during the pandemic, the value of securities whose gains extend far into the future soared. Shares of tech companies like Zoom and Netflix, already boosted by the shift to remote work and home entertainment, looked even more desirable as bond yields all but disappeared. Their rise propelled the US stock market.

Lately, however, real long-term interest rates have jumped in anticipation of monetary tightening, causing a reversal of fortune. The turnaround has been dramatic for more speculative stocks and newer instruments such as cryptocurrencies.

The effect of higher rates on the real economy is slower and more difficult to anticipate. Ultra-cheap money has allowed companies to raise vast capital in 2021, a boom that will not be repeated.

Homebuyers took on big mortgages as house prices soared. Struggling businesses have taken advantage of government-backed loans. Public debt-to-GDP ratios have exploded, due to large and long-lasting deficits in the rich world and a growth slump in many emerging economies.

High indebtedness makes the global economy more sensitive to changes in monetary policy. Central banks need to raise rates enough to curb inflation, but not enough to tip economies into recession as interest charges rise.

Intraday market volatility was striking, reflecting investors' difficulty in digesting the consequences of monetary tightening.

Allie Joseph/AP

Intraday market volatility was striking, reflecting investors’ difficulty in digesting the consequences of monetary tightening.

Households have stronger balance sheets than one would expect given the depth of the recent recession, but their health depends in part on keeping asset prices high. And if monetary tightening at the Fed causes turbulence in emerging markets, the consequences could ripple through the US economy.

As they aim for a narrow airstrip, central banks are also facing strong winds, due to the risk of war in Ukraine and uncertainties related to the pandemic.

Economists are struggling to predict how many people who left the workforce in 2020 will eventually return – and the more they do, the less likely a damaging wage and price spiral will take hold.

They are also grappling with doubts about when consumers will shift spending towards services, easing upward pressure on goods prices caused by clogged supply chains.

Economic data has become more difficult to interpret. If retail sales fall, for example, does this reflect a weakening economy or a welcome return to normal consumption patterns?

Uncertainty about the strength of the global economy and its ability to withstand higher rates, combined with trigger-timidity from central banks as they worry about inflation, means markets are entering in a new phase.

For much of the pandemic, cheap money drove asset prices to astonishing heights even as the global economy bottomed. Today, they are closely linked to his fate.

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