Since Lehman Brothers left the mortal coil, there have been more than 600 rate cuts. Over the same period, central banks have injected over US$12 trillion under QE (Quantitative Easing) programs into money markets. Over US$26 trillion of government bonds are now trading at yields of below 1% with over US$6 trillion currently yielding less than 0%.
These policies, according to policy makers, have been crucial to the ‘recovery’.
Financial market valuations have increased but remain reliant on low rates and abundant liquidity. The effect on the real economy is less clear. Policy makers argue that without these actions to support growth, employment and investment would have been weaker. It is a proposition that is, of course, impossible to test.
Now there is increasing confusion about future interest rate policy.
For the last 12 months, US Fed Chairman Janet Yellen has prevaricated about increasing interest rates. The Fed has not had a rate increase for 112 months. This is the longest period ever since World War 2 with the previous longest being 49 months between May 2000 and June 2004.
Markets expect that stronger US employment numbers will drive a rate rise in December 2016. Puzzlingly, the fed Chairman has also hinted that more QE or negative interest rates are also possible, should conditions dictate.
There is little agreement amongst the Fed Governors about the appropriate policy path. Yellen also has to worry about non-terrestrial matters. Representative Brad Sherman recently told Janet Yellen that God does not want her to raise interest rates until May: “If you want to be good with The Almighty, you might want to delay until May. God’s plan is not for things to rise in the autumn, that is why it is called fall“.
The Fed’s OMC (the Open Market Committee) is now referred to commonly as the Open Mouthed Committee or, more charitably, the Open Minded Committee.
Everyone else is cutting rates.
In Europe, ECB President Mario Draghi has already hinted that he will consider lowering rates further soon. European central banks are already operating negative deposit rate policies. The ECB is at minus 0.20%, Swiss policy rate is minus 0.75%; Sweden’s policy rate is minus 0.35%.
In October, Italy sold two-year debt at a negative yield for the first time. Investors are now paying to lend to a country which has one of the highest debt-to-GDP ratios in the world. It is also a country synonymous with pizza, pasta, political gridlock and fiscal indiscipline.
The Bank of England has suggested that UK interest rates may not increase until 2016 or even 2017.
The Bank of Japan (“BoJ”) has promised additional easing if necessary “without hesitation“. The Japanese have even rebranded QE as – QQE (Quantitative and Qualitative Easing). The Qualitative is central banks talking about easing.
The People’s Bank of China, China’s central bank, cut benchmark interest rates for the sixth time this year to a record low of 1.50% in a bid to support an economy which is forecast to grow at its slowest annual rate in 25 years.
Further interest rate cuts are forecast in Australia, New Zealand and many emerging countries.
Central bankers argue that the case for increasing rates is limited.
Despite record levels of monetary stimulus, growth remains lacklustre. Forecasts of economic activity have seen regular downgrades over the last 2-3 years. Disinflation and deflationary pressures remain, with low commodity, especially energy, prices likely to continue. Overcapacity in many industries limits the ability to increase prices.
Even in the US, where the economy is performing better than other developed countries, wages pressures are limited. Fed Chairman Yellen’s concerns about tight labour markets miss the point that the market is now increasingly global. There are significant surplus labour forces in other nations which can be accessed through global supply chains.
Central bankers dismiss criticism that the policies are, at best, ineffective and, at worst, damaging.
Low rates have created problems for savers and retirees around the world. Pension funds are in trouble with rising levels of unfunded liabilities. German Finance Minister Wolfgang Schaeuble has drawn attention to the increasing solvency problems of insurance companies and retirement funds in an environment of low or negative rates.
Debt levels are continuing to rise from unsustainable to even more unsustainable. Low rates have distorted financial markets and created asset price bubbles in shares, property, and other investments.
Whatever the initial benefits, low rates and unconventional monetary policy are increasingly counterproductive. Former Bank of England Governor Mervyn King spoke for many when he questioned the continuation of these policies: “We have had the biggest monetary stimulus that the world must have ever seen, and we still have not solved the problem of weak demand. The idea that monetary stimulus after six years … is the answer doesn’t seem (right) to me”.
Japanese interest rates have been around zero for almost a decade. The BoJ has undertaken nine rounds of QE. The central bank balance sheet is approaching 70% of GDP. It owns a significant proportion of the outstanding stock of government bonds and equities. But the policies have not restored growth or addressed the problems of demographics or need for changes in Japan’s economic model.
The effect of further rate cuts is also diminished by continuing trade and currency wars. Each individual cut is increasingly offset by competing reductions elsewhere in the world. Despite denials by policy makers, countries are using monetary policy to devalue currencies to gain competitiveness and capture a greater share of global demand. Individual nation’s actions are now redundant in a nugatory race to the bottom in interest rates and currency values.
Maintaining interest rates at low ‘emergency’ levels for an extended period also makes it increasingly difficult to increase them to more normal levels. Increase in debt levels, made possible by lower rates, means the financial impact of higher rates is attenuated.
This is evident in the concern that a potential 0.25% increase in US rates has created.
In Australia, a 0.15-0.20% increase in mortgage rates to reflect increased capital to be held against these loans caused significant uncertainty in the domestic housing market.
In the US, a 1% increase rates would increase US government interest costs by around US$180 billion from its present level of around US$400 billion. Unless offset by increased economic activity, it would increase the budget deficit and government debt levels.
The normalisation of rates to say 2.50-3.00% may prove financially and economically destabilising.
Low rates and QE have also reduced the political appetite for needed policy changes. Lower Interest costs have sapped the willingness for fiscal reforms, debt reduction and structural reforms.
Asset markets, especially equities, have rallied repeatedly on the continuation of low rates. Like Oliver Twist, investors have lined up to demand “more”. But low rates reflect slower economic activity and economic weakness rather than strength. This means, at some stage, a dramatic reassessment of asset prices is now inevitable, either because interest rates increase or because they do not.