From Hero to Zero: Why Loose Monetary Policy Holds Back Growth
Cometh the hour, cometh the appropriate policy response. In the first quarter of 2009 the Western world looked into the abyss of deflation and depression and was pulled back from it by its central banks. Zero, or near-zero, interest rates together with "asset purchases" or the even fancier-named "quantitative easing" (money printing to you and me) were just the tonic to rescue economies that had crashed on the back of banks failing and real-estate bubbles bursting.
And since then…plus ca change….Let's leave QE for this week, I've written enough about it, the circle of money it represents and how we need to start unwinding it, however slowly, now. What is even more of a concern is the continuing zero interest rate policy. On current expectations central banks will not be raising rates until 2015 (Federal Reserve), 2016 (Bank of England) or even later (ECB). That is many years after the onset of recession. We know the reasons why the central banks wish to do this, here is why it is now the wrong policy.
In the retail space people are happy to run with variable rate mortgages because they expect rates to stay low for some time. In the corporate space long-term capital projects are put off partly because of uncertainty and partly because of worries about economic stagnation, but also because the low rate environment means there isn't the urgency to fix long-term financing, one can fund at low rates in the short term for many years to come, right?
The paradox of the low rate environment is that after a time it actually holds back economic activity. There isn't the need or urgency to fix medium or long-term financing because the sub-conscious expects rates to stay low for…well, forever.
Technical proof of this is easily determined from even a casual glance at the Treasury, Gilt or Bund yield curve. We noted the negative interest rate on the German Schatz issue last week, what about 10-year Gilt yields at 1.73 percent? The term premium, an orthodox and logical expectation that longer-dated bond yields should carry a higher rate, has all but disappeared. Why would any rational investor accept a 10-year interest rate of 1.73 percent when today's inflation rate has a big-figure 2 or 3 percent on it? (The simple answer is "because everyone else does, and one has to put one's money somewhere…").
The worst aspect (yes, I mean worst) is the frothy equity markets, with equity indices on both sides of the Atlantic reaching highs last seen before the bank crash but based on...what exactly? The housing overhang remains, unemployment is a serious, serious concern and productivity is struggling under the weight of Asia-Pacific competition. And this is to completely ignore public sector deficits and Eurozone worries.
But we know the answer to that one: an ocean of cheap liquidity. Banks are now surplus of cash and simply cycling it back to the central bank. Zero interest rates are fuelling the equity boom. Another house of cards being built.
What would happen if we started raising rates? Looking beyond the first day, it should become evident to everyone that this is a sign of strength, economies are now ready to start walking without the central bank crutch. Individuals and corporates will start arranging longer-term financing deals, and the correction in equity markets will present a better picture of value – which should resume its upward trajectory.
Loose monetary policy has done its job. It is now holding back investment decisions, it risks being permanently wired into investors' collective psyche and the paradox is that it no longer has a positive impact on economic activity. And it's not as if the central banks would suddenly raise rates by 100 basis points. A 25bps rise in one quarter is the most one can expect. How difficult would that be to absorb?
Five years after the onset of recession and the effect of interest rates at 0 is becoming analogous to an import tariff or a government subsidy to a failing industrial company. It is skewing the investment decision and misallocating resources. Time to start raising rates.
Professor Moorad Choudhry is at the Department of Mathematical Sciences, Brunel University and author of The Principles of Banking (John Wiley & Sons Ltd 2012).