John Rapley

Talk about a globalised economy. Last week, when New Zealand's central bank raised interest rates, bond markets around the world plunged. New Zealand's banking system - hardly a global epicentre - may be like the proverbial Chinese butterfly of chaos theory. When it flapped its wings, it did so in a world economic climate ready for a storm.

The world economy has been awash with money. Between the effects of the Asian boom, and the efforts by western central banks to keep their economies out of recession, money has been cheap for the better part of a decade. Interest rates have been low, credit terms easy.

While this fuelled global economic growth, inevitably, it also drove up asset prices. Real estate surged and stock markets boomed across the world. Inflation thus began building in the world economy. Recently, therefore, central banks began tightening money supply, raising interest rates and limiting access to credit. However, bond markets ignored them.

When a govern-ment sells a bond, it promises to pay its buyer a fixed rate of interest. If the interest rate is attractive, the investor may bid up the price. This reduces the effective rate of interest the bond delivers. Thereby follows the rule that bond prices and bond yields (the interest rate) move in opposite directions.

Short-term interest rates

Over the last few years, as central banks raised short-term interest rates, bond investors drove down yields on government securities. There resulted an economic anomaly - an inverted yield curve, when short-term interest rates rise above long-term ones.

Inverted yield curves seldom last. The longer the term of a loan, the greater the risk that inflation will erode its value; hence lenders demand higher rates in return. However, Asian central banks, flush with cash thanks to their growing economies, were storing reserves in the U.S. and buying treasury bonds, driving down U.S. interest rates. This, in turn, set the standard for other bond markets.

Since private banks compete with governments to borrow money, their interest rates follow those in the government sector. So across the board, interest rates fell.

The efforts by central banks to rein in money supply were failing. While they were warning that growth was accelerating and inflation rising, investors were betting that global growth would slow and inflation would abate: investors apparently reckoned that if they held out, central banks would eventually abandon the tug-of-war and lower short-term rates.

Vindicted

Then came a rush of data from all the major economic poles - the U.S., Europe, Britain, China and India. Everywhere, growth was picking up, and inflation continued. Central banks were vindicated.

New Zealand's interest-rate rise would prove to be the straw that broke cheap money's back. The message was sent: central banks would keep tightening, and it was time for bond markets to fall in line.

They did so, in style. Around the world, interest rates surged, and subsequently held at new levels. This suggests the world economy may have entered a new era, in which cheap money will become a memory.

Because the world economy is healthy, rising interest rates will not likely halt growth. But asset prices will fall. In some places, they may fall sharply. China faces a particular challenge, since its stock market might collapse just when millions of ordinary Chinese have crowded into it.

Closer to home, a new challenge emerges. Jamaica benefited from the era of cheap money, and was able to substantially reduce interest rates thanks to the liquidity of the world market. Those happy times are probably over. Henceforth, further reductions in borrowing costs - upon which economic growth depends - will have to result from actions taken at home.