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Saturday Feature
Borrowers beware, G3 central banks hang tough
Mike Dolan

          After flooding the world economy with cheap money for four years, the world's Big Three central banks are issuing a common message: "Borrower beware."
In the space of just a few weeks, the U.S. Federal Reserve, the European Central Bank and the Bank of Japan have all transmitted heightened inflation alerts, many fretting openly about the risks from sustained rises in energy prices.
Mindful that energy-fueled spikes in inflation can get embedded in the long-term expectations of markets, companies, wage-bargainers and shoppers if fuel prices stay high, policy-makers seem intent on heading that off.
Policy-makers seem intent on heading off any chance that energy-fueled spikes in inflation can get embedded in the long-term expectations of markets, companies and wage-bargainers.
The banks, which set benchmark borrowing costs for the world's richest economies, are working at differing speeds given the varying strengths in their economies.
But economists reckon the confluence of their rhetoric should at least warn borrowers and investors of the risk of significant, across-the-board withdrawal of global liquidity over the next six to nine months.
"If the Fed's intent on pushing rates to 5 percent as we expect, it's not going to be pretty for financial markets," Jim O'Neill, Chief Global Economist at Goldman Sachs said. "If the Japanese withdraw liquidity and Europeans keep making noises about raising rates, that's going to be a real challenge."
Despite robust growth rates, interest rates adjusted for rising inflation have actually eased in recent months and remain close to zero in all three major economic areas.
This has not gone unnoticed by the central banks or the markets, where bond yields and gold -- which set an 18 year high at $475 per troy ounce last month -- are pushing higher.
"Heightened inflation concerns have not been limited to the U.S. or the Fed," Larry Kantor, head of economics at Barclays Capital, said in the bank's latest global outlook.
The Fed has already raised rates 11 times over the past 15 months, lifting its key borrowing rate in regular quarter-point moves to 3.75 percent from 1 percent in June 2004.
But just as some started to mull whether it was done tightening, amid the uncertainty of hurricanes in the Gulf Coast, the central bank has stepped up its anti-inflation rhetoric and signaled more rates are in the pipeline.
This week alone, at least four senior Fed officials warned about heightened inflation risks.
Dallas Fed Bank chief Richard Fisher said on Thursday inflation was "edging closer to the upper end of the Fed's tolerance zone, with little inclination to go in the other direction."
On Monday, Atlanta Fed Bank chief Jack Guynn said inflation risks were "elevated". On Tuesday, St. Louis's William Poole said he had "no doubt" the Fed would respond to gains in core inflation and Philadelphia's Anthony Santomero said the Fed would have to continue moving policy to "a more neutral one".
The tone has hardened across the Atlantic too.
Markets generally expect the ECB will leave its key rates at 2 percent, where they have been for more than two years, for another 3 months to 6 months. But ECB President Jean-Claude Trichet was markedly more hawkish after this week's policy-making meeting.
"Strong vigilance with regard to upside risks to price stability is warranted," Trichet said. "It is essential that the increase in the current inflation rate does not translate into higher underlying inflationary pressures."
The Bank of Japan is in a different boat. It has spent years trying to lift the economy out of a deflationary spiral, doing is utmost to create inflation by keeping interest rates at zero for 4 years and pumping cash into the banking system.
But even the BOJ is talking tough too. With the economy recovering smartly and signs of inflation emerging at last, it has signaled it will soon stop handing cash to the banks.
Over the past month, many of the nine BOJ board members sent strong signals the bank is moving closer to ending its so-called "quantitative easing" policy.
Ultra-cheap borrowing was key to the fastest world growth rate in decades last year and an abundance of cheap cash has flowed into assets such as houses, equities and bonds.
The risk that asset prices get out of hand and fall quickly and disruptively is making central bankers doubly nervous and helping push them toward a gradual withdrawal of liquidity.
One manifestation of the continued wash of money has been a sharp narrowing of interest rate premiums on risky assets such as sovereign bonds in emerging markets, where spreads over U.S. Treasury rates have fallen by a third in the past year.
This so-called "under-pricing of risk" was a key topic at last month's meeting of the Group of Seven finance ministers and central bankers -- which along with the 'Big 3' central bankers included their British and Canadian counterparts.
Fed Vice-Chairman Roger Ferguson, in a presentation to the G7 meeting, warned of high levels of risk taking in markets.
"Low interest rates invite all sorts of behaviors that create their own set of dynamics that you've got to watch," one U.S. official said on the fringes of the G7 meeting. "Rates that are low for a long time create all sorts of pressure in an economy."


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