02 Dec 2016
By Chungwei Hsia
Since the global financial crisis of 2008–2009, many central banks around the world have been lowering interest rates further and deeper. The past year has been something of a watershed as more monetary policy makers and countries have even adopted negative nominal interest rates — once viewed by many experts as a practical impossibility and something that couldn’t be implemented as a sustained policy tool.
The theory behind the continued lowering of rates and other quantitative easing (QE) such as pumping money into financial systems by buying assets — as, for instance, the U.S. Federal Reserve, the European Central Bank (ECB), and the Bank of Japan all have done — is that low rates will spur growth and reflate economies. Yet we’ve seen seven years of ever-cheapening rates and loose monetary policies without much positive economic effect. Instead, we have been mired in an environment characterized by two chilling fundamentals: low inflation and tepid global growth.
So why aren’t global economies reacting to these stimuli? And is it possible that unprecedented policies such as extreme QE and negative rates could eventually start undermining the very economic environment that policy makers are trying to correct?
In the following sections, we’ll examine these questions, looking at some potential economic implications for this unique global monetary-policy environment, and discuss whether a natural “equilibrium rate” exists — a concept that major economic theorists have debated.
Chart 1. Global growth has grown sluggish
Falling to levels not seen since the global financial crisis
Source: Bloomberg, June 2016.
Chart 2. More yields are becoming more negative over time
Increasing number of countries going below zero
Source: Bloomberg, June 2016.
What's behind all the unconventional easing
Major central banks have turned to unconventional QE and zero or negative rates as their primary monetary policy tools to stimulate growth. Lowering the cost of capital through lower interest rates should, theoretically, induce more investment and economic growth. Although that’s how it’s supposed to work, it hasn’t played out as expected despite rates’ sinking lower and being more pervasively negative.
Is it possible that we could reach a point where incremental investment opportunities begin to dry up in a prolonged low rate environment? One example that comes to mind is the overinvestment in China that has led to overcapacity in many Chinese industries.
After a decade of superheated growth in the early 2000s, Chinese policy makers have scrambled for ways to continue to grow without resorting to a broad-based easing program due to concerns about debt. China is one of the few major economies with a nominal interest rate still meaningfully higher than zero, but the reasoning behind its reaction remains the same — the difference between investment return and the cost of borrowing is generally what will dictate investment decisions. Or, looking at it another way, lowering interest rates to zero or less than zero may have exhausted the investment opportunities available.
A set of savings-investment diagrams conceptually illustrate this argument. The series of charts below shows what hypothetically can occur with the savings-investment dynamic as monetary policy lowers nominal interest rates. The first chart represents the original value created by the difference between investment return and the cost of borrowing. The savings line (supply curve) drops with a rate cut and QE, two of the primary monetary policy tools used when economic growth is weak or inflation is below the desired rate. As the interest rate declines and the savings line falls, the resulting intersection with investments, or the demand curve, moves further toward the corner. That makes the available surplus smaller and smaller as the savings line approaches the lower boundary of zero. The end result in this hypothetical example is a liquidity trap, where injections of cash from monetary policy efforts are ineffective, resulting in a lack of interest in borrowing.
Liquidity traps have been observed in a number of developed markets in recent years, and some have blamed banks for not intermediating credits. Yet perhaps one underlying reason for the low desire to invest has been lack of opportunities, rather than lack of funds for lending. One telling point may be found in the recent observation of a number of U.S. corporations seeming to hoard cash and/or paying dividends as their capital expenditures continue to decline year over year.
With this as a backdrop, it’s hardly a surprise that monetary policies are showing much less impact on real economies in recent years. Going further into the negative rate territory, shown as the dashed line in the last chart, would only seem to make things worse. In that scenario, borrowers might want to simply collect the positive carry and not bother investing in an economy where new opportunity is already scarce.
Chart 3. More yields are becoming more negative over time
In this theoretical example, the yellow "savings" line falls with each step of loosening monetary – a cut in the interest rates QE – leading to a liquidity trap.
Charts are for illustrative purposes only and are not intended to convey the results of any particular investment.
The bigger picture that has contributed to the current environment
An ominous backdrop to the global landscape, in which central banks have nearly exhausted their monetary policy tools, is the debt supercycle. As we’ve discussed in our Great Risk Rebalance series, a series of debt cycles has been documented since World War II. Following these periods of debt buildup, the government and central bank typically would step in with policy actions in an effort to reflate the economy.
In the current debt cycle, attempts to reflate have occurred largely through the creation of government debt. In our view, it would appear that the world is at the point where the chief borrowers are governments and the chief lenders are central banks. That leaves, essentially, no other authority to reflate the economy. Currently, central banks have taken an even more prominent role to try to address the economic situation and, as we have seen, have increasingly turned to more extreme policies like negative rates.
While negative interest rates do have some historical precedent, they have been extremely rare. Based on research conducted by my Sydney-based colleague Patrick Er, neither during the Great Depression nor at the height of the global financial crisis have negative rates surfaced or remained for so long.
Unintended consequences of low rates
Low and subzero rates can trigger a number of inadvertent consequences. First, low rates tend to damage the stability of the overall financial industry, when financial firms and other market participants find themselves forced either to take additional risks through lower-quality investments, or to attempt to prevent losses by scaling back on activities. For example, banks may invest more aggressively to maintain profits, or insurers and pension funds may take on more risky assets to match the corresponding liabilities. In contrast, banks can pull back on lending to prevent losses, and insurers and pension funds could stop taking on new liabilities. Both scenarios can hurt the real economy.
Moreover, the additional liquidity can make its way into financial assets and create asset bubbles that potentially endanger the overall stability of the financial system. One effect of central banks’ large asset purchases — one of the unconventional monetary policy actions used in recent years — has been to occasionally create illiquidity in the financial markets as the central banks have become among the largest holders of bonds or equities. The result can mean distortions in asset price and masking of such aspects as the risk-reward profile and discipline of the real economy and financial markets. Ultimately, this type of outcome constrains the ability of central banks to hike rates in the future.
Chart 4. Asset prices have followed Fed holdings
Source: Citi Research, Haver, Bloomberg.
Instead of increased spending, consumers are saving
As profound an effect that sustained negative rates can have on investments in both real and financial assets, there is also a larger impact on the global economy as a whole, and on overall prospects for growth. For example, negative rates were supposed to encourage not only businesses to invest, but also consumers to increase their spending. Instead, it appears that what is increasing is saving.
Consumers are saving more, for instance, in Germany (a savings rate of 9.7% of disposable household income in 2015 is expected to rise this year to 10.4%) as well as in Japan, which moved to negative rates in early 2016. In other euro-zone countries, household savings rates have edged higher since the ECB first pushed rates below zero in 2014. In Denmark, Switzerland, and Sweden, three non-euro-zone countries with negative rates, savings are at their highest since 1995. Companies in Europe, the Middle East, Africa, and Japan have been tending to hoard cash rather than invest. (Source: The Wall Street Journal; the Organization for Economic Cooperation and Development.)
In the household sector, the expectation was that negative rates would make saving deposits less attractive and spur consumption. But saving trends like the above suggest that consumers are more influenced about the outlook for their income than interest rates. Businesses may have similar concerns that outweigh access to low-cost borrowing. (Source: Macquarie.) These developments add to the questions concerning the potential unintended consequences that negative rates may have over time.
Looking for an equilibrium rate
In the United States following the global financial crisis, the shadow rate (used to quantify monetary policy in a low interest rate environment) remained in negative territory through the end of 2015, the result of the ultraloose monetary policy.
The Fed is mandated to target both the unemployment rate and the inflation rate in order to try to achieve an equilibrium rate. Historically, the Fed has been able to approximate the equilibrium rate by applying what is known as the Taylor Rule. Named after Stanford economist John Taylor, the Taylor Rule describes the system of monetary policy of lowering short-term rates when economic growth is weak and raising them when it’s strong. Theoretically, at an equilibrium rate, the economy can grow in an ideal combination of full employment and with no excess inflation above its target (currently a 2% inflation target). However, while we have seen steady improvement in the official unemployment rate and “within range” inflation reported in 2016, the Fed has so far repeatedly chosen not to raise rates since its single rate hike in December 2015.
Chart 5. The Wu-Xia shadow fed funds rate
Source: Federal Reserve Board of Governors; Jing Cynthia Wu and Fan Dora Xia.
Adjusting the policy rate (fed funds rate) is one way the Fed can employ monetary policy. After the global financial crisis, when the rate was hovering near zero and short-term rates could not be reduced any further, the Fed used other means such as QE to suppress rates, making it difficult to gauge policy implementation. As a result, researchers have been attempting to create what are known as “shadow rate” models to quantify monetary policy. The shadow model often used is the one developed by Jing Cynthia Wu and Fan Dora Xia.
Chart 6. Tracking the actual fed funds rate against the Taylor Rule
The Taylor Rule is an interest-rate forecasting model invented by economist John Taylor. This chart shows the difference between the rate suggested by the Taylor Rule and the actual fed funds rate.
Source: Federal Reserve Bank of Atlanta
Continued low rates in the U.S. are expected — even if a modest rate hike occurs relatively soon — and this prompts further theoretical questions: Is the economy now behaving differently than it ever did before? Can an equilibrium rate based on traditional factors be achieved?
A new approach?
A new set of thinking about interest rates and the equilibrium rate has been the subject of debate among economists. For example, Harvard economist Lawrence Summers has suggested since 2013 that world economies are so imbalanced with slowing growth that even zero nominal interest rates would be too high to try to stimulate growth. The natural interest rate, he has contended, should be much lower; that is, well below zero.
Meanwhile, James Bullard, president of the St. Louis Federal Reserve Bank and formerly considered an inflation hawk, recently changed his practice of projecting for aspects like economic growth and target policy rates. Instead, economic factors and policies may shift abruptly in the short term with regime switches, he proposed. In promoting this view, Bullard suggested that the mismatch of the Fed’s slow pace of rate increases compared with what the Federal Open Market Committee (FOMC) had mapped out for 2016, could be causing confusion and distortions in the global financial markets. Bullard has suggested that one more rate hike by the Fed may be in the offing this year. However, others, including Fed Chairwoman Janet Yellen, have not ruled out negative rates in the U.S. at some point if necessary.
These are all further signs that the correlation between conventional rate decisions and economic reactions have weakened. Instead of central bank actions producing results most would expect, there only seems to be random and noisy economic data in a weak growth environment. This suggests that the global economy may now be operating outside of conventional norms, and subject to factors that are no longer effectively managed by monetary policies.
Negative rates have yet to achieve the expected stimulus effect. Instead, they could be producing an environment where equilibrium is less attainable.
What investors can do in a slow growth–low rate environment
With interest rates and growth rates expected to be lower for longer, investing is likely to continue to be challenging. Investors may want to consider these points for their fixed income portfolios.
- Expect lower returns. Particularly in a time when negative rates are dragging down yields globally, it can be critical to adjust expectations for performance of the asset class in general.
- Remain diversified. This primary rule for all investors becomes even more important in challenging market environments.
- Gain a comfort level with holding credits for longer. Even for those who don’t consider themselves buy-and-hold investors, it may be time to consider longer holding periods. Being too nimble in an uncertain environment can lead to costly mistakes.
- Turn to the professionals. Low yields and other challenges can make active management attributes – like researching credits and managing fixed income portfolios in a disciplined way – even more important. Especially in a time of slow growth and low rates, investors may find that this kind of environment is best handled by active managers.