Since the global financial crisis of 2008, major central banks successfully implemented extraordinary monetary policies by bringing interest rates to near zero and implementing large-scale asset purchases to help avoid an economic collapse equivalent to the Great Depression.
Although we commend central banks for their actions and acknowledge the difficulty in removing these policies, we believe that the intended effects—to promote growth and inflation, and provide economic stimulus—may be getting overwhelmed by some unintended consequences.
In recent years, the global economy has failed to gain the sufficient momentum for central banks to exit their extraordinary policies. In addition to maintaining very large balance sheets, the U.S. Federal Reserve (Fed) has maintained an ultra-low interest rate policy, and the European Central Bank (ECB) and the Bank of Japan (BOJ) have implemented negative policy rates, along with quantitative easing (QE), throughout an economic expansion. These prolonged periods of ultra-low and negative rates (ULNR) may actually be contributing to a slow growth and nondynamic economic backdrop.
Here are four unintended consequences.
|1.||Consumers save vs. spend.|
As real (inflation-adjusted) interest rates move into negative territory, the “cost” of savings increases, rendering consumption a more attractive alternative to saving. This is known as the substitution effect. Historically, negative real rates produced a strong positive effect on consumption. Going forward, however, this relationship may not hold. During the past five years, all three major central banks had negative real rates, but consumers’ savings rates rose in each country.
The demographic impact of an aging population appears to be overwhelming the substitution effect. The proportion of the population in retirement—a group who typically spends the greatest proportion of income—has risen dramatically during the past several years in the United States, Europe, and Japan (see chart).
If interest rates remain low, retirees (and the insurance and pension instruments that service them) may have to either curtail spending, because low rates generate less income, or choose to reallocate into higher-returning, higher-yielding assets. The first reduces consumption, and the second may move potentially vulnerable income-seeking investors into an investment mix with too much risk given their investment time horizon.
Furthermore, a growing percentage of the population is age 50–64, which includes the highest earners, who, in aggregate, spend the most dollars. However, ultra-low rates are likely causing them to increase their savings rates to ensure a comfortable retirement.
|2.||Higher investment prices primarily benefit top income groups.|
One of the most obvious beneficial effects of ULNR policy has been a surge in stock and bond prices. Since the Fed brought the fed funds target rate to the zero lower bound in December 2008, stocks have increased by double-digit annualized gains in the United States, the eurozone, and Japan, and the decline in bond yields has increased bond values. Although prices have surged, the top income groups have benefited the most, experiencing the greatest increase in net worth. The positive wealth effect on household spending has been smaller in wealthy households than in lower-income households.
|3.||Credit growth becomes inhibited.|
Another central bank goal of ULNR is to provide financial entities with cheaper funding costs to help lower borrowing rates and promote credit growth. Again, the reality appears quite different. In each of the three large economies, credit growth has been well below the rate of previous recoveries, even considering the muted demographics. ULNR policies reduce bank profitability by pressuring net interest margins (NIMs). In fact, recent research from Federal Reserve Board (FRB) economists concludes that reduced bank profit margins have deterred banks from extending loan activity.1
We agree with the FRB economists’ analysis. If the borrowing rate, or “price,” drops too low to cover the fixed and variable costs of making a loan, then banks would be generally better off using capital to grow non-lending businesses, buy back shares, or engage in mergers and acquisitions (M&A). In a similar vein, insurance companies and pensions may increasingly find that ULNR have created dramatic asset and liability mismatches, reducing profitability and creating a need for additional capital. Therefore, we believe ULNR do not incentivize credit creation but may rather ultimately tighten economic conditions. The market seems to also agree with this. Upon central banks’ implementation of negative policy rates, European and Japanese bank stocks declined dramatically in the days and weeks that followed (see chart).
In fact, we’ve seen prolonged low rates have a major impact on Japan, where rates have been kept near zero for more than 20 years. Japanese bank NIMs have dropped to the lowest in the world, averaging less than 1%. Such a low margin has reduced banks’ willingness to take risk and extend credit to portions of the economy in most need of growth. Instead, these banks have implemented major overhead cost reductions to just 0.50% of total assets (see chart), and have concentrated lending activity in the lowest risk segments of the economy.
In essence, Japanese banks have shifted their main focal point of revenue growth from interest income to fee income and bond trading. But fee revenue is essentially a tax on consumers and businesses (much like negative rates), whereas bond trading income has very little beneficial impact on the real economy. Banks within the eurozone and Japan have price-to-book ratios averaging below 1.0, indicating a uniquely negative outlook to their profitability.
Finally, one goal of ULNR has been to soften an overleveraged economy. By lowering borrowing costs, ULNR policy can improve household and corporate balance sheets by reducing debt payments. Unfortunately, in many cases, deleveraging did not occur (e.g., Japan, Europe) or may have been slowed by ULNR.
While introducing low rates mollifies the initial sharp downturn, maintaining ultra-low rates well after a recovery prevents much needed structural adjustment. A dynamic, capitalist, market-based economy allows weak businesses to fail and stronger, high-productive firms to gain market position. Those high-productive firms enjoy sufficient returns on investment to warrant new hiring and new investment. However, extremely low financing rates stymie this market-based “creative destruction,” and lower productivity by slowing the consolidation of excess capacity and prolonging the lives of unprofitable companies. One recent example would be the shipping industry, where unprofitable ships remain in operation as the very low cost of funding, coupled with the drop in steel prices, creates an environment where it is cheaper to run on extended credit than to scrap a ship for steel.
While there were multiple causes of low productivity in the United States during the past several years, ultra-low interest rates have likely contributed to the decline by keeping unprofitable companies in business.
What may be more effective
We commend the Fed in 2008 for bringing interest rates to near zero, and for enacting QE and other extraordinary policies to combat the effects of a devastating financial crisis. But with conditions significantly more stable, higher levels of interest rates may be appropriate. While the rise in rates may create credit distress in the industries struggling with excess capacity, unprofitability, and low productivity, it’s also possible that debt restructuring, more effective bankruptcy laws, and the rebuilding of corporate profitability will allow the major advanced economies to begin to escape an environment of low investment and deflation.
With monetary policy reaching its limits, there are other, more effective strategies. A greater focus on structural reforms, programs to help populations adjust to changing economic realities, and prudential counter-cyclical fiscal policy may help move the large, developed regions such as Japan, Europe, and the United States toward a higher growth, higher employment, and higher return environment. The unwillingness or inability of fiscal authorities to do this, however, has kept central banks enacting and maintaining ULNR, which could be counterproductive and yield unintended consequences—including slower growth and greater financial instability.
- Read Viewpoints: “June business cycle: Is monetary policy all that matters?”
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