Rethinking low interest rates

Over the years, prevailing economic orthodoxy has tended to follow fashions with policy makers pursuing a particular course of action only to subsequently switch tack and repudiate what has gone before. Very few people today believe that fixed exchange rates are a good idea (unless you happen to be in the euro zone where the rates of member countries have been fixed against each other for more than 20 years). Quaint ideas such as targeting money supply have also fallen from favour. Even the notion of using fiscal policy as a countercyclical tool, which was banished from the lexicon in the 1980s (apart from a brief reappraisal in 2008-09), is now part of the policy armoury. I thus wonder how long it will be before central bankers revisit the question of whether low interest rates do as much harm as good.

It has long been my view that central banks around the world made a policy error in not normalising monetary policy more swiftly in the wake of the 2008 crash. Although the contraction of global liquidity in the wake of the Lehman’s bankruptcy warranted a massive monetary response, there were few good reasons to justify why monetary conditions in 2012 were required to be quite as easy as those prevailing at a time of financial Armageddon. The Riksbank was one of the few brave enough to begin a tightening cycle in 2010 but the Swedish economy was caught in the backwash of euro zone turbulence and the central bank was forced to cut rates even below post-Lehman’s levels. I have often suspected that this policy about-turn deterred other central banks from making similar moves ahead of the Fed or ECB.

This is not to say that global interest rates needed to go back to pre-2008 levels. Factors such as demographics and the sharp slowdown in productivity growth justify a lower equilibrium real rate. However, one of the things economists warned about was that holding rates too low reduced the scope for conventional monetary easing in the event of an exogenous shock. That shock duly arrived in the form of the Covid pandemic and given the limited scope for rate cuts, central banks were forced to swell their balance sheets to unprecedented levels. This has opened up a whole can of worms. On the one hand it has sparked inflation fears whilst on the other it has led to significant market distortions, pushing up both bond and equity markets.

The inflation issue

Dealing first with inflation, this is a subject which has been at the top of the agenda throughout this year with the US 10-year yield hitting a 12-month high of 1.74% in March versus 0.91% at the end of 2020. At his annual shareholders meeting at the weekend, Warren Buffett warned that “we are seeing very substantial inflation.” Joe Biden’s huge US fiscal expansion plans have further raised concerns that the economy may overheat and Treasury Secretary Janet Yellen’s suggestion that “it may be interest rates will have to rise somewhat to make sure that our economy doesn’t overheat” sent ripples through equity markets which have been driven to record highs on the back of ultra-expansionary monetary policy.

However, we may be overestimating the link between monetary policy and inflation. The academic literature is unambiguous that there has been a change in the inflation process over the past 20 years. There is less agreement on whether that represents a weakening of the link between inflation and activity growth or whether the decline in inflation volatility is due a reduction in the volatility of economic shocks. In my view the former explanation counts for more in a world in which the rise of China as a major production centre has changed the dynamics of the global economy. That being the case, central bank actions in the industrialised world have played less of a role in driving down inflation than they like to believe. Accordingly, they may have less power to prevent any significant acceleration. Furthermore, if the link between inflation and the economy is less well defined than many suppose, it is harder to justify low interest rates on the basis of low inflation.

Are prolonged ultra-low rates even effective?

Whether inflation does or does not accelerate is not the focus of debate here. The bigger concern is that central banks appear fixated only on inflation as a measure of determining whether interest rates are at appropriate levels whilst ignoring a number of other factors. Indeed whilst central banks are right to take their inflation mandate seriously, there are a number of downsides associated with an ultra-easy monetary policy.

Starting with the bigger question, how sensitive are industrialised economies to interest rates anyway? My own modelling work always came to the conclusion that the UK was never particularly sensitive to interest rate moves. More detailed academic work by Claudio Borio and Boris Hofmann at the BIS suggested that monetary policy tends to be less effective in periods of ultra-low interest rates. They noted further that “there is also evidence that lower rates have a diminishing impact on consumption and the supply of credit.” Two reasons were given for this: (i) the conditions which prompted a cut in rates to the lower bound in the first place (a balance sheet recession) generate economic headwinds which make recovery more difficult and (ii) the impact of low rates on banks’ profits and credit supply generate feedback effects which impede recovery. We only need ponder the Japanese experience of the past 20 years to realise there may be something in this.

The market impact

Although the economy in the industrialised world has not boomed in the last decade, equity markets clearly have with the Shiller 10-year trailing P/E measure on the S&P500 last month trading at a 20-year high of 36.6x. Prior to the March 2020 collapse I did note that the prevailing level of 31x pointed to a market that was too expensive but we are now at the second highest levels in history (chart below) – lower than in 1998-2001 but above 1929 levels.

This in turn raises a question whether central banks have a duty to take account of financial asset prices in their monetary policy deliberations. Former Fed Chairman Greenspan used to take the view that we could not spot a market bubble until it had burst and that the role of monetary policy was to mop up after the fact. That view no longer holds since we can clearly identify that US markets are in bubble territory. To the extent that central banks are increasingly responsible for financial stability it is incumbent upon them to ensure that the banks which they monitor will not be adversely impacted by a market correction. In fairness, banks are subject to regular and rigorous stress tests and central banks are confident that capital buffers are sufficiently large to withstand a major market shock.

However, the gains from high asset valuations generally accrue to high income households which has distributional consequences for the economy. Central banks can rightly argue that this is not part of their mandate and is therefore not something they have to worry about. But to the extent that governments, which set the mandate, do care about distribution there is a case for central banks to at least think about this problem before it is forced upon them. Then of course there is the ongoing problem of what low interest rates do to savers, particularly those with an eye on retirement – a problem I have highlighted on numerous occasions. Most people do the bulk of their retirement saving in the last ten years before they leave the workplace – precisely the time when they are advised to reduce equity holdings and overweight their pension portfolio towards fixed income. Pension annuity rates remain nailed to the floor in this low interest rate environment (chart below) which means that retirees get a much smaller payout for any given pension pot than they did in the past. Low rates clearly have generational consequences.

Last word

I am not advocating that central banks should imminently raise interest rates. Indeed any such move is only likely to occur well into the future. But in a post-Covid environment where fiscal policy is likely to be much looser than in the wake of the GFC, there will be less need for monetary policy to do most of the heavy lifting. This should at least stimulate a proper debate about the pros and cons of ultra-low (and in some cases negative) interest rates which has been lacking over the past decade.