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.

Stay positive or turn negative?

In recent weeks the Bank of England has given the impression that it may be prepared to take interest rates into negative territory. Although the debate has gone a bit quiet of late, it has not gone away, perhaps because the BoE believes the economic collapse in April was not quite as bad as previously expected or, and this is my preferred take, it was only ever a device to jawbone market interest rates as low as possible.

The economist Silvio Gesell was one of the first proponents of negative interest rates in the nineteenth century when he proposed a tax to dissuade people from hoarding cash. But it was never seriously tried in a policy context until the Swiss introduced a policy of negative rates in the 1970s in a bid to prevent foreign investment flows from driving the franc higher. However the policy was deemed a failure and the idea was eventually abandoned in 1978 after an experiment lasting six years. In the wake of the 2008 financial crisis the idea came back onto the agenda with Denmark being the first mover, again as a means to hold the currency stable. This time, other countries followed suit with the likes of Switzerland (again), the euro zone, Sweden and Japan all driving rates into negative territory. Both the US and UK have resisted the charms of negative rates, largely because there is a presumption in the Anglo Saxon world that the monetary transmission mechanism ceases to operate properly with interest rates below the lower bound.

There are many good arguments against negative rates

In the current policy framework, the banking sector is charged a negative interest rate on its cash deposits at the central bank. Banks have an incentive to run down their cash holdings and either lend more into the wider economy or pass on the negative cost to their customers who run down their money holdings, and in the process stimulate the economy as they spend their cash. However, low interest rates and flat yield curves distort time preferences for households and companies, which results in sub-optimal resource allocation (e.g. they allow zombie companies to operate which would otherwise cease trading). Central bankers who have observed the experience of Japan over the last two decades cannot be blamed for calling into question the usefulness of ultra-lax monetary policy. Ironically, in the late-1990s I remember half-jokingly suggesting to a Japanese economist that the BoJ should consider negative rates. It was probably not my greatest idea in retrospect.

Furthermore, ultra-loose monetary policy distorts markets. By reducing the returns to cash holdings, investors have an incentive to seek higher returns by loading up on risky assets, which in turn results in widening disparities between market prices and fundamentally justified levels. No investor would question the view that low rates have helped markets to blow out.

For all that, there is no good reason in theory why interest rates should not go negative.  After all ancient mathematicians regarded negative numbers as “false” and it was not until the late seventeenth century that respectable mathematicians such as Leibniz began to take them seriously in Europe. Today, however, we are all familiar with the concept and we might wonder why they were ever regarded with such suspicion.  Moreover to the extent that real economic quantities respond to real interest rates, we have long become used to the notion of negative real rates with nominal interest rates lower than inflation.

Yet there is something of the taboo about a negative nominal interest rate. Perhaps one reason is that the interest rate represents the cost of time: it represents the return derived from waiting; from saving rather than consuming. Perhaps it offends the Puritan streak in the western psyche. Or maybe because the arrow of time only runs in one direction, a negative interest rate somehow inverts the cost of time and is therefore perceived as unnatural. Whatever the reason, many people have difficulties with the concept of negative central bank rates.

For all the evidence amassed by the likes of the ECB suggesting that negative rates have helped to stimulate the economy, we should treat the arguments with a pinch of salt. Without any doubt, negative interest rates penalise savers. Unless we are forced to work long past our planned retirement date, we all need to make provision for old age and this is made all the harder by low or negative interest rates. There may be an argument in favour of temporarily trying to boost the economy by cutting rates into negative territory but the ECB has held the depo rate below zero for six years. I fear that a prolonged period of negative rates will ultimately prove counterproductive as individuals attempt to raise their precautionary saving.

But consider this …

One of the key features of all the countries that have experimented with negative rates so far is that they run a current account surplus i.e. there is a surplus of domestic saving with respect to investment (chart). Both the UK and US run current account deficits – they suffer from deficient domestic saving. At first glance, you may ask whether negative rates in these economies are such a good idea if they encourage further dissaving. In a static framework, they are not. But let’s try to think through the dynamics. Encouraging households to bring forward spending should widen the current account deficit in the near-term and ought, in theory, to result in currency depreciation. This in turn should generate higher imported inflation, which after all is how central banks have justified their actions, and allow them to respond by returning interest rates towards positive territory.

In this framework the key transmission mechanism is the exchange rate. If the cut in interest rates is not sufficient to produce concern in the FX market, the negative interest rate policy will not have the desired effect. This might be because the pickup in consumption is insufficient to generate a current account deficit so the currency market remains unconcerned. Or it might be due to the fact that the currency in question (the likes of the Swiss franc, yen and euro) acts as a safe haven, particularly since rates elsewhere are also extremely low. In either of these cases, perhaps interest rates will have to be pushed so far into negative territory to have the desired effect that the side effects would be unacceptable. But this begs the question whether they would work better in an economy which already runs a current account deficit, and where the FX market is perhaps more sensitive to external deficit concerns. The pound would certainly be such a candidate.

I would be hesitant to advocate the BoE cutting interest rates into negative territory because the experience elsewhere shows that once they go below the zero line, it proves difficult to get them back up again. But if I were a maverick on the MPC I would at least try to ensure that this argument gets a hearing and make the case for a short, sharp dip into negative territory with the unspoken assumption that they will be raised after (say) two years. There is nothing to be gained by holding rates below zero for long. But there also seems little to be gained from a prolonged period of holding them so close to zero they might as well be negative.

Monetary policy at the limit

As the global economy recovered in the wake of the 2008-09 bust, many economists noted that central banks would have to raise interest rates as a precautionary measure in order to give monetary policy some headroom when the next downturn struck. That downturn appears to be here and central banks do not have much conventional ammunition left in their locker, even though markets are increasingly pricing a BoE rate cut this month having dismissed such a prospect at the start of last week (chart). Central bankers continue to sound confident about their ability to cope. Is this simply a case of them trying to underpin market sentiment or are there grounds for confidence?

A speech last week by outgoing BoE Governor Mark Carney was a case in point. In summary, Carney emphasised that further asset purchases and additional forward guidance mean that central banks have more scope than is commonly supposed. But the speech had a valedictory air about it, highlighting the successes of the BoE’s monetary policy during Carney’s near-seven years in office without touching on the downsides, and we have to look through some of the spin in order to assess whether some of the policy prescriptions still stand up. That said, central banks have had more policy successes than failures over the past decade so we should cut them some slack. After all, if the likes of the ECB had not done “whatever it takes” to hold the euro zone together in 2012, the economic history of the past decade could have been very different (and not in a good  way).

Turning first to the issue of forward guidance, this was one of Carney’s big ideas when taking office in 2013 through which the BoE would indicate how it would set monetary policy contingent on economic conditions. Despite the Governor’s claims for its success today, the reality in 2013-14 was very different. Recall that the BoE made it clear it would not raise interest rates so long as the unemployment rate remained above 7%. In the event unemployment fell much more quickly than anticipated, yet rates were kept on hold. Clearly, a commitment not to raise rates so long as unemployment is above a threshold level is not the same as a commitment to raise them when it falls below it. But there was a significant degree of confusion surrounding the policy and it is more than a stretch to claim, as Carney does now, that “people understood the conditionality of guidance.”

One of my retrospective criticisms of the BoE’s forward guidance policy is that it quickly abandoned the published unemployment rate as a target variable in favour of the output gap, giving rise to the suspicion (whether justified or not) that it no longer suited the BoE’s purposes. As I noted in written evidence to a parliamentary committee in 2017, “since the measure of spare capacity was determined by the BoE, this meant that outside observers became increasingly reliant on the information feed from the MPC to determine the future policy stance. The clarity of rule-based forward guidance policy was lost.”

Is there a future for forward guidance? Despite my reservations about the way in which it has been implemented in the past, I believe it does have a role to play – although maybe a less important one than Carney believes. In my view, forward guidance has a much more prosaic role. By communicating its objectives to as wide an audience as possible on a regular basis, it should be possible to remind people of the things that the central bank focuses on and thereby encourage the public to observe a particular set of variables, thereby giving it a better idea of how the central bank is likely to react. I am not sure that the message is getting through, however. Despite numerous BoE communications regarding the current below-target rate of inflation, the most recent Bank of England/TNS Inflation Attitudes Survey, conducted in November, suggested respondents believed the current rate of inflation was 2.9% (it was actually 1.4%) and the 12-month ahead forecast was for a rate of 3.1% (the BoE expects it to be significantly below 2%).

Carney also made the case for additional QE. On the basis of his calculations, further asset purchases of around £120bn (0.5% of GDP) is equivalent to 100 bps of interest rate cuts. Adding in the near 75 bps of conventional rate reductions, which would take Bank Rate to near zero, and the (unspecified) impact of forward guidance he reckons the BoE would be able to deliver monetary easing equivalent to 250 bps of rate cuts, which just happens to be the average in pre-2008 monetary easing cycles. However, it is what he did not say that is telling. It may be possible to deliver a one-off monetary boost of the magnitude that Carney suggests, though that is questionable since it is acknowledged that the marginal impact of QE diminishes as central banks buy more assets. But it is not possible to deliver it on a repeated basis without taking away some of the initial stimulus when the economic picture improves (which is, of course, what European central banks have not done in the past decade).

Another issue that Carney did not address are the long-term consequences of lower for longer. Savers have foregone a significant amount of interest income over the past decade. The response to that is savers should have taken cash out of the bank and bunged it into equities, but that does not seem to be a prudent policy which central bankers should endorse. Indeed, Carney argued that “the vast majority of savers who might lose some interest income from lower policy rates stand to gain from increases in asset prices that result from monetary policy stimulus.” But that is not very helpful when the asset in question happens to be your home as it is not so easy to realise the capital gain (unless you plan to significantly downsize). As for pensions, central bankers are aware that keeping rates low has a major impact on future pension returns but they do not talk about it much in public. However, annuity rates continue to fall which means that the future value of our pension pots is a lot less than it used to be. I thus continue to believe that the long-term consequences of a prolonged low interest rate policy will only be felt in the very long-term, by which time it will be too late to do anything about it, and today’s generation of central bankers will be long gone.

For all central bankers continue to tell us that they have more ammunition in the face of a downturn, the ECB under Christine Lagarde is no longer as gung-ho about a lax monetary stance as it was under Mario Draghi, since it realises that negative rates have significant side effects. Although the likes of Carney and Draghi can, with some justification, argue that their loose policy prescriptions were the right choice at the time the real problem is that rates remained low for much longer than was necessary on the basis of prevailing economic conditions. The problems associated with this are becoming increasingly evident and sooner or later I fear we will all pay a price.

Beware the ultra-long trap

The bond market world has moved into strange territory of late. Around one quarter of the debt issued by governments and companies is currently trading at negative yields and in Germany government bonds are yielding negative rates of interest out to a maturity of 30 years. In effect, investors are paying the government for the privilege of owning their debt, quite a long way out across the maturity spectrum. This does not mean that investors periodically hand over a sum of money to the government, but it does mean that the stream of income that the bond pays is less than the amount the investor paid for the bond.

Why would anyone be prepared to do that? The simple answer is that investors need the reliability and liquidity that high quality bonds can provide when they have to allocate their portfolio over a wide range of assets. Think of it this way: Even though investors would have maximised their returns over the past decade if they had been fully invested in equities, at no point could they ever be sure that the bandwagon would keep on rolling. Theory suggests that long-term returns are maximised if the portfolio is spread across a range of assets, and the likes of pension funds are required to allocate a minimum portion of their portfolio to bonds in order to meet their payout obligations. Even now pension fund providers will not hold less than 40% of their assets in bonds, and although the returns may be miserable the buyers of high quality government (and corporate) debt are highly likely to get their money back. The bond market is thus a safe place to store wealth – a hedge in an uncertain world.

On the basis that demand for bonds is unlikely to dry up, despite low interest rates, governments arguably have a strong incentive to issue debt at current low rates, either to finance additional spending or refinance existing debt. Moreover, they have an incentive to issue much longer maturity debt than previously in order to lock in these rates for as long as possible. One would think that no rational investor worth their salt would buy bonds issued with a negative coupon rate. Think again. In August, the German Federal Finance Agency sold a 30-year zero coupon bond (i.e. it pays no interest) but because the bond was sold at 3.61% above par (i.e. investors pay 103.61 but receive only 100 at maturity) this amounts to a negative interest rate of 0.11% per annum if the bond is held to maturity. Demand fell short of target, with sales of €824 million versus a target of €2 billion, but it was generally perceived as a useful trial of the extent to which the market was prepared to accept low rates.

In 2017, before yields fell to current levels, two countries – Austria and Argentina – decided to test the demand for ultra-long issuance by selling 100 year bonds. Their experience has been rather different, with the price of the long-term Argentinean bond since halving in value whereas the Austrian bond has doubled. It is understandable that Argentina tried to lengthen the maturity of its debt profile – it has been a serial debt defaulter over the last 70 years with five episodes of default or rescheduling since 1950, so it made sense to reduce disruptions caused by debt rollovers. But this history also weighs on investors. Can Argentina really be trusted not to default on its debt in the next 100 years? In order to get investors onboard, Argentina had to issue at a coupon rate of 7.9%. That might seem high in the context of the US or Europe, but with the central bank benchmark rate at 74.98% and 10-year yields currently trading at almost 28%, it does not sound quite so bad.

One country which could conceivably get away with issuing longer dated bonds at low coupons is the US where the Treasury, which only issues as far ahead as 30 years, is mulling the possibility of going even further out along the curve to maturities of 50 and even 100 years. Treasury Secretary Steven Mnuchin said last month that “we are looking at potentially extending the portfolio. If there is proper demand, we will issue 50-year bonds.” He went on to suggest that if these bonds prove to be a success, the US would consider the possibility of 100-year bonds. Historically, the US has issued debt at longer maturities and between 1955 and 1963, it sold bonds at maturities up to 40 years (here). In 1911, it even issued a 50 year note to fund the construction of the Panama Canal.

But as attractive as long-term issuance sounds, there are a number of factors to consider. History cautions that issuers have to strike a balance between offering yields which are sufficiently attractive to investors but which minimise the costs to the issuer, and as the US found in the 1950s and 1960s that is a difficult balance to get right. One of the reasons for sticking to the current maturity schedule is that the US Treasury has tried to avoid tactical or opportunistic offerings of debt, and has focused instead on maintaining a regular and predictable schedule. This has helped the US Treasury market to become amongst the most liquid financial markets in the world. This in turn allows the government to offer relatively low coupons in return for the privilege of liquidity and helps to keep down Federal debt servicing costs. Issuing ultra-long debt threatens to reduce market liquidity which might in the long-run push up US rates.

Odd as it may sound, almost 20 years ago there were fears that rapid US growth and declining budget deficits would lead to a shortage of Treasury securities. Obviously that never happened, but in a world where there is a move to increasing the duration of debt we could get to a situation where there are temporary issuance droughts which could distort the shape of the yield curve. If there is an increase in the proportion of debt issued at longer maturities, a prolonged period of reduced issuance – perhaps because of rapid growth and smaller fiscal deficits – could mean a shortage of supply at the short end of the curve which would push down yields (i.e. raise prices) and result in a significant steepening of the yield curve. The point may be hypothetical but it demonstrates that changing the duration of debt issuance could have significant market consequences.

It is a mark of desperation that investors would even consider buying such long-dated bonds, particularly at a time when global uncertainty appears so high. Although the US continues to issue the world’s reserve currency, in which case it makes sense to buy dollar bonds, we cannot say that will be the case in 100 years’ time. Nor can we be sure that even the US will be able to pay its debt. After all, those British and French creditors hoping that the Russians would finally pay up on their pre-1918 debt are still waiting. And if we cannot be sure that even the US will pay up, who can we trust?

A negative view of negative rates

My views on the disadvantages of low interest rates have been set out on this blog over recent years and increasingly there are indications that this view is moving into the mainstream. Indeed, across large parts of Europe the debate is not about low rates but rather negative rates. The theory of negative rates is simple enough: Banks are penalised for holding excess liquidity on deposit at the central bank and therefore have an incentive to lend it out. Whilst this policy may work for a limited period of time, it is now more than five years since the ECB lowered the deposit rate into negative territory. 

Today’s move to reduce it further to -0.5% may well be counterproductive although the ECB has finally recognised that forcing rates lower will simply impact on the bottom line of the banking sector and have introduced a system of tiering to provide some form of relief. Nonetheless, the negative interest rate policy is not having the desired effect and rather than continue with more of the same, it is time to reconsider our monetary options.

It is ironic that on the same day the ECB announced changes to monetary policy, the Swiss Bankers Association issued a strong statement decrying the SNB’s negative interest rate policy, arguing that “the societal, structural and long-term damages will become even greater the longer we find ourselves in this ‘lower forever’ environment.” SBA Chairman Herbert Scheidt argued that “negative interest rates are causing massive structural damage to the Swiss economy and disadvantages for the country’s citizens. They result in bubbles and damage the competitiveness of the Swiss economy long term because they keep unprofitable companies alive artificially. Negative interest rates also put the pensions of Swiss citizens at risk. A further lowering of interest rates would further exacerbate this issue. The longer negative interest rates remain in place and the greater the structural damage for Switzerland, the more urgent it becomes to ask from which point onwards countermeasures must be taken against negative interest rates.”

There are a lot of strong arguments there which deserve to be taken seriously. The idea that zombie companies are kept alive artificially is of short-term benefit to those who would otherwise be put out of work, but in the longer-term it hampers the efficient allocation of resources throughout the economy to areas where returns are higher. I have long argued that pension fund returns will be dampened by excessively low interest rates and a report this week highlighted that annuity rates in the UK have fallen to historic lows. Every £10,000 in the pot yields just £410 – down 12.3% from the start of the year – compared to between £900 and £1100 in the 1990s. In effect, buying an annuity to generate a guaranteed lifetime income will, in the words of pension expert Ros Altmann, “mean poorer pensioners for the rest of their lives.”

The impact of loose monetary policy on boosting financial markets to levels which look way out of line with fundamentals has been well documented. Although conventional P/E measures suggest that equities look extremely expensive in a historical context, the fact that the dividend yield on stocks is significantly higher than bond yields for the first time in almost 60 years means that investors are unlikely to dump equities any time soon (chart). By raising the net present value of housing services, low interest rates have also boosted house prices above fundamentally justified levels (a subject to which I will return). 

 

There is, of course, a risk that if markets have been inflated so much by low interest rates, any attempt to raise them will cause the bubble to deflate quickly. Central banks concerned with maintaining the stability of the financial system will be keen to avoid such an outcome. On this reading of events, the lower rates go and the longer they are maintained, the more difficult it becomes to raise them. The US may provide a counterfactual where markets continued to perform strongly despite the fact that the Fed was raising rates, but this was partially owed to the Trump Administration’s corporate tax cuts so the jury is still out.

We should not overlook the fact that central banks can only impact on the supply of credit and its price, but not demand, and we are increasingly at the point where reducing interest rates is akin to pushing on a string (to use the phrase attributed to Keynes). But I had an interesting discussion with a colleague who suggested there is nothing special about negative rates per se – the main problem is that positive rates have been baked into so much contract law that we struggle to deal with negative rates. He described a case of two identical derivative contracts where one receives a floating rate payment over the period of an EONIA contract whereas the other defines a fixed payment calculated on the reference (EONIA) rate. Both are essentially the same instrument in a world where interest rates are above zero but they are treated differently in a negative rate world because interest payments “cannot be negative” whereas the fixed payment can.

In a similar vein, the Finnish financial regulator is currently trying to assess whether it is legal for banks to pass on negative rates to retail depositors. Different countries have taken a different approach to this problem, with some refusing to levy the charge on retail customers. But this raises a question of whether depositors might simply withdraw their funds from one country and place them in another euro zone country where depositors are protected. To the extent that the period of negative rates has lasted longer than anyone initially anticipated, banks’ business models are going to have to change. Last month Jyske Bank in Denmark announced it would issue 10-year mortgages at a rate of -0.5%, although the bank will not lose money on the product since fees and other charges will be sufficiently high to ensure a profit. This may well be a template for the rest of Europe where fees and charges are likely to rise as banks struggle to make a profit in a world of negative rates.

It appears that ECB Council members were not unanimously in favour of the measures adopted today, with the central bank governors of France, Germany and the Netherlands reportedly opposed to a resumption of bond purchasing. Their views on negative rates are not known but this is an indication that northern European central bankers believe we are very near the limits of what an expansionary monetary policy can achieve. Mario Draghi may thus have delivered a poison pill to Christine Lagarde, who takes over as ECB President at the start of November. With Draghi having maxed out the credit card during his tenure, it will fall to Lagarde to deal with the consequences.

The reality of real interest rates

With interest rates having been so low for so long in the industrialised world, policymakers are increasingly waking up to the need to take away some of the monetary stimulus put in place almost a decade ago. The Federal Reserve started its tightening process in December 2015 and it was joined last week by the BoE which nudged the benchmark rate above 0.5% for the first time in over nine years. But it is generally recognised that although central banks are beginning to take away some of the monetary stimulus, they are not heading back to pre-2008 levels any time soon.

In a bid to understand how much headroom there is for monetary policy, central bankers are increasingly paying attention to the neutral real interest rate, described by former Fed Chair Janet Yellen as “the level that is neither expansionary nor contractionary and keeps the economy operating on an even keel.” More formally, it can be thought of as the rate which balances desired wealth holdings with desired capital holdings. This is the theoretical framework attributable to the Swedish economist Knut Wicksell in which equilibrium in both the goods and financial assets market is simultaneously derived.

The analysis published last week in the BoE’s Inflation Report explained this framework very nicely (see chart) and noted that we can think of the rate as being driven by long-term secular factors (R*) and a short-term component reflecting cyclical issues (s*). John Williams, recently elevated to the role of President of the New York Fed, noted in a speech earlier this year that in his view the real neutral rate (R*) in the US is around 0.5%. The BoE comes to a similar conclusion for the UK, pointing to R* in the range 0%-1% (with a modal estimate of 0.25%).

These estimates are around 200 bps lower than those prevailing 20 years ago. So what has changed? One of the key secular factors is demographics. As people live longer they have to save more for retirement with the resultant increase in savings putting downward pressure on interest rates (a shift in the red line to the right in the BoE’s chart). Another important factor is the increased demand for safe assets which has driven down returns on government bonds relative to those on riskier assets, and which also has the effect of driving the red curve further to the right. A third factor is the slowdown in productivity which has reduced business demand for capital, thus putting additional downward pressure on the interest rate (the blue line shifts to the left). Finally, a rise in the government debt-to-GDP ratio may depress the real rate via a crowding out effect since this reduces the quantity of capital available to finance an expansion of the business capital stock.

As to how these factors will play out in future, there is general agreement that slower population growth in the western world will not reverse the current trend ageing of the demographic profile. Consequently, retirement saving is likely to remain a key driver putting downward pressure on the equilibrium rate. It is less clear what will happen with regard to productivity. It may recover, or it may not, but we cannot say for sure that it will remain as sluggish as it has over the last decade. In any case, as labour force constraints begin to bite, it is possible that demand for capital will rise which will act to raise the neutral rate. But it is unlikely that government debt-to-GDP ratios will decline rapidly any time soon, which argues for continued downward pressure on the equilibrium rate.

However, some doubt has been cast by the BIS on the link between interest rates and the observable proxies that are conventionally used to measure the savings-investment balance. Part of their argument rests on the fact that much of the analysis is based on data only back to the 1980s and that taking the data back to the late nineteenth century suggests a weaker link between them. That said, the BoE’s analysis is  based on a long-run of data extending back more than 100 years and they come to much the same conclusion as the rest of the academic literature, which weakens the BIS criticisms to some degree.

However, the BIS does raise another important question:  Much of the literature assumes that monetary policy is neutral in the long run and that only real factors influence the real interest rate. But is this necessarily true? For one thing, the expected wealth demand function may be determined by the actions of central banks themselves as interest rate expectations influence portfolio choices. Another objection is that we may underestimate the key channels through which monetary policy exerts a persistent influence over real interest rates (e.g. the inflation process or the interaction between monetary policy and the financial cycle). These are serious criticisms, although the BoE’s framework introduces the short-run variable s* into the framework, and whilst we can estimate R* using conventional measures, the BoE does not try to put a numerical value on s*. However, it does suggest that in the longer-term the s* component will tend towards zero (although it may not be zero at any given time).

What are the takeaways from all this? First off, if we add a 2% inflation rate to estimates of the real neutral rate, we end up with a neutral funds rate in nominal terms of around 2.5%. With the Fed funds target corridor currently set at 1.75%-2.0%, we might only be three 25 bps hikes away from the neutral rate. Similarly, the UK neutral rate is estimated in the range 2%-3% so we do appear to have more headroom. Nonetheless both estimates suggest that interest rates will not get back to the pre-2008 rates of 5%-plus for a long time to come. Welcome to the new normal.

The case for a UK rate hike

The Bank of England is widely expected to raise interest rates by 25 bps this week, taking them above 0.5% for the first time since March 2009. The markets seem convinced, pricing such an action with a probability around 90%. It would be a major surprise if the Bank were not to deliver, with the markets so apparently sure. Indeed, if the BoE had a problem with current market pricing it would almost certainly have said something before now to try and nudge expectations. The fact that it has not done so is a strong indication in favour of a policy tightening. (If a rate move is not forthcoming … well, that is another story and we will deal with it if it happens).

There are those who believe that raising rates is a mistake (or at the very least that there is no need to act now). Their argument is sound enough: Price inflation is slowing; wage inflation is not picking up as anticipated and there are sufficient headwinds from Brexit that caution is warranted. If we were talking about an economy in which rates were a little bit higher than those introduced when the economy was about to fall off a cliff in 2009 I would be a bit more receptive to that view. But we’re not! Whilst Bank Rate of 0.5% may have been appropriate for an economy which was expected to contract by more than 3% in real terms, it is hard to make the case that is still the right interest rate 9 years later for an economy expected to grow by 1.5%.

For quite some time, I have believed that the UK rate setting process has taken an overly short-term approach to monetary policy. By looking only at short-term issues (e.g. the latest inflation or growth data) policymakers have been able to defer the need for a policy tightening. But in so doing, they appear to have suffered from what we might term “horizon myopia” without taking account of the fact that all these short terms eventually add up to an extended time horizon.

My argument for raising rates is the same as it has been for the last 3-4 years: The current interest rate is too low for general economic conditions. Those who believe that nominal GDP growth should act as a benchmark for the policy rate – and I am semi-persuaded of the merits of such a policy – argue that UK interest rates have deviated from GDP to an unprecedented degree in recent years (see chart). By itself, that is not proof of anything but it is an indication of the extent to which financial rates of return are out of line with those in the real economy which is likely to lead to economic distortions.

Arguably, excessively low (or high) interest rates distort capital allocation decisions – for example, by propping up zombie firms (though I am not sure that is a problem in the UK right now). However, they do distort savings choices. If returns to saving are low, this is a strong argument in favour of spending rather than saving. This is, of course, precisely what policy was designed to achieve during the depths of the recession but is it really necessary almost a decade on? And as I have pointed out previously, the longer interest rates are held at emergency levels, the bigger the risks to future generations of pensioners whose pension pots will not grow as rapidly as they ought. Indeed as John Authers noted in the FT last week whilst low interest rates prevented an economic meltdown, “it grows ever clearer that risk has been moved, primarily to the pension system.”

In my view, this is another strong argument in favour of modestly tightening monetary policy. At this stage we are not talking about a dramatic stamp on the brakes, but allowing rates to edge upwards by (say) 50 bps per year for the next couple of years would take some of the heat out of the problem. Whether the BoE will be in a position to do that depends, of course, on the extent of any damage that Brexit inflicts on the UK economy.

Silence can be golden

If you had asked me a week ago, I would have said that a rate hike of 25 bps by the Bank of England in May was a high probability event. However, I had reckoned without the intervention of BoE Governor Carney who warned in a BBC TV interview last week that any such move was not a done deal. In his words, “there are other meetings over the course of this year” at which a rate hike can be delivered. As a consequence, the implied market probability attached to a 25 bps hike collapsed from 80% last Thursday to 52% today, thereby turning a near-certain rate hike into a toss-of-a-coin event (chart).

It would appear that Carney was trying to warn the market that a string of weaker data argues against treating a May hike as a given. On the one hand, CPI inflation has slowed more rapidly than the BoE expected in its February forecast, coming in at 2.7% in Q1 versus a predicted 2.9%, with the March rate slowing to 2.5% - the lowest in twelve months. Then there is the likelihood that Q1 GDP growth will come in weaker than expected, posting a rate of 0.2-0.3% q-o-q (an annualised rate of 0.8% to 1.2%).

Whilst these are mere statements of fact when viewed in isolation, in my view neither are good enough arguments to postpone the rate hike. For one thing the weak activity data are largely the result of cold weather at the beginning of March (remember the Beast from the East?). In the sense that this is a temporary factor, we should be looking through it to assess the underlying strength of the economy especially since: (a) there may well be a partial countermovement at the start of Q2 and (b) previous attempts by the ONS to measure the impact of a cold spell on activity growth have tended to be revised away (as occurred in Q1 2012 for example when the initial GDP estimate posted quarterly growth of -0.2% but now shows a rate of +0.6%). As for inflation, it has long been known that it would begin to slow after peaking in the early months of 2018. The BoE has been softening us up for a monetary tightening on the basis that inflation is above target but now that it is less above target than expected, it seems they are backing away from their long-held view.

Around the same time as Carney was making his comments, MPC member Michael Saunders argued forcefully that “the economy no longer needs as much stimulus as previously” and that in terms of the pace of hiking “’gradual’ need not mean ‘glacial’”. That was a direct contradiction of Carney’s view – as is the right of external MPC members – but it sends a conflicting message to both markets and individuals and very much calls into question the usefulness of forward guidance as a policy tool. 

Forward guidance is designed to provide greater clarity about the central bank’s view and reduce uncertainty about the future path of monetary policy whilst delivering a robust policy framework. The Governor’s intervention just three weeks before the May rate decision does nothing to enhance clarity; has introduced more, not less, certainty about the path of interest rates and the differing messages from policymakers suggests that the policy framework is anything but robust. It is not as if this is the first time the Governor has blown a hole in the communications strategy. His comments at the Mansion House speech in June 2014 hinted strongly at a rate hike that did not materialise and led MP Pat McFadden to dub Carney “the unreliable boyfriend.”

As I have argued before (here), policymakers are making a mistake by focusing on the change in interest rates conditional on current economic circumstances when what really matters is the level of interest rates conditional on general economic conditions. Even if Brexit is curbing economic activity, as Carney argued, the economy is by no means falling off a cliff and therefore does not need interest rates at levels consistent with the threatened meltdown of 2009.I fully understand policymakers’ caution. After all, it is not just the markets that they have to convince: It is those individuals whose economic prospects are dependent on the path of interest rates. But I cannot help thinking that on credibility grounds, the MPC would be better advised to deliver the May rate hike they had strongly trailed, and allow themselves a more fierce debate about whether there is a need for additional tightening. As it is, they almost now cannot win. If they do raise rates next month it will call into question why Carney needed to wade into the debate. But if they don’t, it will raise questions about the message that the BoE was communicating in the two months prior to last week. Silence can be golden.

The BoE and a bit of cold turkey

It is widely expected that the Bank of England will raise interest rates this week for the first time since 2007. There have been some influential academic voices suggesting that this would be the wrong time to raise rates – the more I think about it, the more I disagree with them. And before we all get carried away, the expected increase from 0.25% to 0.5% would only represent a move from the lowest level in history to the second lowest.

The first reason for disagreeing with some of the wiser heads is purely to do with the signalling effect. Having suggested in September that “some withdrawal of monetary stimulus was likely to be appropriate over the coming months” financial markets have increasingly interpreted this as meaning that a rate move is likely in November and are now pricing such action with a probability of almost 90%. Although the BoE has suggested in the past that a near-term rate hike might be in the offing – which subsequently never materialised – not since Mark Carney assumed his post in 2013 have markets been so convinced about the likelihood of a rate hike at the upcoming meeting as they are now. The only comparable degree of market conviction was in the wake of the EU referendum, when in July 2016 markets fully priced a 25 bps rate cut at the August 2016 MPC meeting (a reduction which was duly delivered).

Of course, it is not the MPC’s job to reinforce the market’s conviction. But to the extent that the strategy of forward guidance relies on the predictability and credibility of central bank communication, any decision to hold interest rates unchanged in view of current market expectations would seriously undermine this plank of monetary policy because it would suggest that communication has not been sufficiently clear.

Another strong argument in favour of raising interest rates is that they are (arguably) too low given where we are in the economic cycle. Much of the academic opposition to a rate hike stems from the fact that wage inflation remains low, and uncertainty surrounding the Brexit decision suggests that this is not a good time to tighten policy. I have sympathy with these views. Indeed, I have argued recently that the inflation excuse used to justify the need for higher interest rates does not wash because it reflects a one-off spike triggered by currency depreciation. But opponents of a rate hike may be guilty of confusing the impact of interest rate levels and a change in rates. Even though the UK economy has lost momentum over the course of this year it is still growing at a rate of around 1.5% in real terms. Inflation, at 3%, is right at the top end of the threshold above which the BoE Governor has to write to the Chancellor explaining what he intends to do in order to bring it back towards target. Moreover, monetary policy is still operating on a setting designed to promote recovery in the wake of the 2008 financial collapse, with an additional bit of Brexit insurance thrown in. The UK simply does not need rates at current levels.

Arguably, the BoE should have raised rates in 2014 or 2015 when growth was back at trend and house price inflation was running at double-digit rates. However, the global interest rate cycle was not then supportive of a unilateral move by the BoE, with the Fed not yet having commenced its rate hiking cycle and the ECB beginning a phase of more aggressive monetary easing. As it turned out, with UK inflation running close to zero during 2015 and H1 2016, the BoE would have run the risk of repeating the mistake of the Swedish Riksbank which began tightening in 2010 only to have to reverse course in the face of a collapse in inflation.

As for Brexit risks, the BoE has been clear all along that this represents an economic shock against which interest rates can only provide limited insulation. In any case, taking back the precautionary 25 bps rate cut implemented in summer 2016 makes sense in view of the fact that the worst case scenario did not materialise. But a wider point is that ultra-expansionary monetary policy can inflict just as much harm as an overly restrictive stance – perhaps in ways we do not yet fully understand. We do know that low interest rates have helped to propel equity markets to record highs and produced an unjustified tightening of credit spreads. To the extent that investors have become less discriminating about what they buy when they are simply chasing yield, low interest rates distort normal market behaviour. And as the Japanese experience has shown, a lax monetary stance is no guarantee of economic recovery.

Rising interest rates will hurt – mortgage payments, for example, will go up which is no fun at a time when real wages are falling. But as those professionals treating drug addicts will tell you, sometimes it is necessary to take a clear look at where we are, how we have got there and accept that a bit of cold turkey is necessary for the longer term good.