Markets across the world have been pushed up by the extremely low interest rates in the advanced economies. How long will they remain low? Are low interest rates an unmitigated good, or do they have also have deleterious consequences? These are some of the questions discussed in the recently published Bank for International Settlements’ Annual Economic Report.
The crux of the problem, says the report, is that ‘central banks find themselves in a predicament, as the path ahead has narrowed. On the one hand, the room for policy manoeuvre has shrunk substantially since the GFC (Global Financial Crisis). Tackling a downturn or a further downward slide in inflation would stretch monetary policy further. This puts a premium on regaining policy space by proceeding along a tightening path. On the other hand, with subdued inflation, signs of weakening economic activity have made it hard for central banks to continue along that path.’
We all know how the markets reacted when the US Federal Reserve indicated that it was set on a course of raising the policy rate late last year. Indeed, this is something that has happened repeatedly -- central banks in the advanced economies try to tighten, the markets throw a tantrum, doubts arise over the sustainability of the recovery and the central banks capitulate. This has led to the belief among investors that central banks will always rush in at the first signs of the markets going into a tailspin. It has led to the all-pervasive ‘buy on dips’ mantra being chanted in the markets. More than ten years after the financial crisis, growth in some economies is still dependent on excessively low, even negative, rates of interest.
So how long can the current low rates of interest continue? The BIS report is clear on this point. It says, ‘Should inflation remain subdued and below central banks’ objectives, despite their forceful attempts to push it up, current economic conditions could continue.’ Why indeed should central banks raise policy rates when inflation is so low?
Why inflation is low despite low unemployment and wage growth in the US is a much-debated topic. The BIS report says it’s because of the lack of bargaining power of the trade unions and also because companies prefer not to pass on input cost increases in a low growth economy. Others have said that a long period of low inflation has dampened inflation expectations. Some have pointed to demographic factors, with an ageing population spending less. Whatever be the reason, the fact is that price rises have been muted over several years now.
Does that mean all is well and that we can echo the famous economist Irving Fisher when he said in 1929, just before the Great Depression, that ‘stocks have reached what looks like a permanently high plateau’? Far from it.
The BIS report says long periods of very low interest rates lead to several distortions. First, it leads to more debt. While aggregate debt, public plus private, plateaued last year, it is much higher now than before the financial crisis. Second, it has led to a global search for yield and lending to risky assets has gone up sharply.
The BIS report says ‘The share of bonds with the lowest investment grade rating in investment grade corporate bond mutual fund portfolios has risen, from 22% in Europe and 25% in the United States in 2010 to around 45% in each region.’ And further, ‘following a long-term decline in credit quality since 2000, the share of issuers with the lowest investment grade rating (including financial firms) has risen from around 14% to 45% in Europe and from 29% to 36% in the United States. Given widespread investment grade mandates, a further drop in ratings during an economic slowdown could lead investors to shed large amounts of bonds quickly. As mutual funds and other institutional investors have increased their holdings of lower-rated debt, mark-to-market losses could result in fire sales and reduce credit availability.’
Third, the real economy too is affected, as zombie firms -- companies that are unable to cover their debt-servicing costs from operating profits and have low growth prospects -- are kept alive due to the very low borrowing costs. The BIS report says such firms ‘sap economy-wide productivity growth not only by being less productive themselves, but also because they crowd out resources available to more productive firms. Evidence suggests that their increase over time has had an economically significant macroeconomic impact.’
In short, financial vulnerabilities are a consequence of ultra-low interest rates. This is seen in the remarkable growth of the leveraged loan market, which now stands at $3 trillion, according to the BIS. The report warns ‘Structured products such as collateralised loan obligations (CLOs) have surged – reminiscent of the steep rise in collateralised debt obligations that amplified the subprime crisis.’
The longer central banks delay raising rates, the more will the vulnerabilities and distortions increase. While the short-term may look fine, the long-term outlook could be fraught with risks. The report says, ‘the side effects of very accommodative policies may themselves reduce the future room for manoeuvre. They may do so by weakening the economy’s ability to withstand higher rates, making any normalisation harder; and by generating financial headwinds that potentially limit policy effectiveness. In particular, raising rates becomes harder if debt burdens have increased and financial markets are more sensitive to monetary policy tightening after prolonged support is withdrawn.’
Then, of course, there’s the slowdown in China. The BIS report says that as the Chinese authorities attempted to deleverage their economy, the slowdown spread quickly to other parts of the world via supply chains. And finally, adding to the slowdown are the trade wars.
The BIS’s prescription for these ills is to rely less on monetary policy and instead use fiscal and other policies to boost growth. ‘Structural reform’ to increase productivity, in particular, has been a favourite nostrum. The problem is this: that structural reform has not happened and instead trade wars have broken out is the result of political pressures that indicate all was far from well with the previous regime of ever-increasing globalization, aka ‘neo-liberalism’. The BIS does not seem to recognize this political economy problem.
Nevertheless, the BIS analysis does make the important point that there are no free lunches and the current regime of ultra-low interest rates and its attendant distortions could well be setting the stage for the next financial crisis.
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