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05/02/2014 12:45 EDT | Updated 07/02/2014 05:59 EDT

Watch Out! The Central Bank Will Raise Interest Rates Soon

In an unprecedented move, the Fed undertook an extraordinary experiment in monetary policy. Unable to further target an interest rate, already at zero, the Fed began announcing a quantity of cash that it would inject into the financial system by purchasing large numbers of government bonds and other highly-rated securities, and replacing them with cash.

Brace yourselves. An unprecedented change is currently underway in financial markets, something not seen in the history of the global economy. For nearly five years, the world financial system has been awash in liquidity, flooded with a torrent of dollars, but the tide is turning. Quantitative easing by the U.S. Federal Reserve Board is likely to cease entirely by the end of 2014, and next year the Fed will shift into a tightening cycle. As the U.S. economy accelerates in 2015, the central bank will have little choice but to raise interest rates. This will have global implications.

And it's not just the U.S.; the European Central Bank and the Bank of England also had increased their asset holdings massively, but are now pulling back or holding steady. Only the Bank of Japan is set to ramp up stimulus in the years ahead in a determined effort to defeat deflation once and for all.

We are still learning about the side-effects of the injection of so many trillions of dollars liquidity, such as the creation of asset bubbles. The removal of trillions of dollars from the global could be equally fraught with unintended consequences and the truth is that we don't really know how it will play out.

The introduction of quantitative easing was absolutely vital in shoring up a collapsing financial system. Back in 2009, there was extraordinary coordination among rich country governments. The G-7 agreed to provide large fiscal stimulus programs collectively amounting to nearly 3 per cent of GDP, while their central banks lowered interest rates simultaneously in a show of strength that the world's largest economies were working together. But this was no ordinary downturn, and interest rates dropped to zero, while credit was still contracting at an alarming pace and unemployment continued to climb.

In an unprecedented move, the Fed undertook an extraordinary experiment in monetary policy. Unable to further target an interest rate, already at zero, the Fed began announcing a quantity of cash that it would inject into the financial system by purchasing large numbers of government bonds and other highly-rated securities, and replacing them with cash. The intention was to stimulate credit growth and lower the cost of long-term borrowing, and it also stabilized the banking system because banks had so much excess cash.

However, a side effect of the excess cash was that some of it leaked into other asset classes such as stock markets, commodities, and emerging market bonds and currencies. A portfolio-rebalancing effect occurred as investors shifted away from low-yielding treasuries and bonds into riskier, higher-yielding asset classes. As stocks, commodities and currencies surged and risk premia plummeted, many emerging market banks and sovereigns became accustomed to having easy access to cheap US dollar funding. This changed radically on May 22, 2013, with the Fed's announcement that economic conditions could warrant tapering bond purchases under the so-called 'QE3' round of monthly bond purchases. The sobering truth is, the tightening has only just begun.

Why? World growth is ramping up quickly. Firms and consumers will need liquidity to engage in theThe introduction of quantitative easing was absolutely vital in shoring up a collapsing financial system. Back in 2009, there was extraordinary coordination among rich country governments. The G-7 agreed to provide large fiscal stimulus programs collectively amounting to nearly 3 per cent of GDP, while their central banks lowered interest rates simultaneously in a show of strength that the world's largest economies were working together. But this was no ordinary downturn, and new growth cycle. If the trillions of dollars of excess cash sitting on bank balance sheets re-enters the real economy through a burst of bank lending, then inflation is likely unavoidable. Central banks are determined to guard against that and so as economic outlook improves, their key task will be an orderly withdrawal of this liquidity. Whether the Fed can achieve this through its 'tapering' process remains to be seen. Markets are already pricing in the expected effects.

The bottom line? We're going somewhere we've never been before, but in various ways, we have done that a lot lately - maybe we're getting used to it. As withdrawal of QE moves the market around, it's critical to bear in mind that growth is the trigger for the process. It seems that some volatility will be a 'necessary undesirable' of the coming cycle.

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