Why monetary stimulus has run out of gas—and what will follow.
Editor's Note: In this complimentary edition of About Everything, Hedgeye Demography Sector Head Neil Howe discusses whether central bank monetary policy has finally reached its limits. Howe explains the broader implications for investors.
Unlike fine wine, monetary policy does not improve with age.
Immediately after the Great Recession, the world’s central bankers had little choice but to slash short-term interest rates as an emergency measure. The earliest to do so was the U.S. Federal Reserve, which cut its benchmark rate to 0.25% following the downturn. The policy worked. Disaster was averted.
But then central bankers decided that what worked well in small doses short term would work even better in massive doses long term. The Fed soon inaugurated quantitative easing (QE), the wholesale purchase of long-term low-risk debt. It all started with QE1 in 2008, but when bankers felt that the economy wasn’t improving fast enough, we got QE2 in 2010 and then QE3 in 2012.
In 2013, Japan made gigantic QE the biggest “arrow” in its new Abenomics quiver. In 2014, the European Central Bank (ECB) became the first major financial institution to institute a negative interest rate policy (NIRP). Earlier this year, the Bank of Japan (BOJ) unveiled its own NIRP, while the Bank of England (BOE) cut its benchmark rate to the lowest level in its 322-year history.
The end result of all this easing? Fully $13.4 trillion worth of negative-yielding bonds are now trading worldwide. In fact, more than a fifth of global GDP is now covered by a central bank that is setting negative rates.
Meanwhile, global GDP growth has slowed, taking us from a weak recovery to an even weaker recovery. Most of the created “money” sits unused as excess bank reserves. And lower long-term rates have done little to spur more consumption—or investment.
WHY LOW RATES LOSE THEIR POTENCY OVER TIME
So how did we end up here?
Let’s put ourselves in central bankers’ shoes.
Lowering short-term rates, for a short period, is a tried-and-true strategy. Monetary authorities have been employing it for centuries. When today’s dollars are made temporarily cheaper in terms of tomorrow’s dollars, consumers and investors splurge today on big purchases that they’ve been putting off. Even lowering long-term rates, for a short period, may work by enriching asset holders and prompting them to spend. The data on QE, however, are still unclear since it involves something of an expectational paradox: Wouldn’t the market bet against any explicitly temporary effort to lower the 10-year yield?
Cushing’s disease of the global economy. Basically, then, monetary easing is more like a steroid than a fine wine. It works great in short-term doses. Long term, its effect on the economy weakens—and can even become counterproductive. When a person overuses steroids, we call it Cushing’s disease. When an economy overuses them, we call it “the new normal” or “secular stagnation.”
How exactly do ZIRP, NIRP, and QE become dysfunctional over time? Let’s count a few of the ways.
First, low interest rates stimulate spending most effectively when people think they’re temporary. When people think they’re permanent, all sense of urgency is lost. I may as well wait until tomorrow to spend—indeed, waiting may reward me with even lower rates.
Second, while low rates may induce consumers to pull future intended consumption into the present, soon there will be nothing left to bring to the present. Every new auto that people want to buy at zero interest for the next several years has already been bought. Now what?
Third, indefinite low rates cause target savers to consume less, not more. Target savers—for example, those preparing for retirement—aim to reach a fixed real dollar sum in some future year. The lower the rate, the more of their income they need to save to reach their target. Falling rate assumptions are forcing corporations to jack up the DB pension deductions they are subtracting from worker payroll. Super low-rate economies like Denmark, Switzerland, and Sweden now have the highest personal savings rates in decades.
Finally, low-rate policies that stay endlessly on hold tell people that central bankers do not expect the economy to recover anytime soon—and we know that pessimism is anathema to both consumers and investors. And on its current course, maybe the economy won’t recover. There’s the bleak prospect, floated by the likes of Fed Governor Lael Brainard, that much of the decline in long-term rates is not policy-driven at all—but rather is driven by demographic aging and declining labor productivity.
In practice, NIRP kills financial institutions. So much for the pitfalls of cutting interest rates too long. What about the pitfalls of cutting them too low? NIRP works fine if the natural rate of interest is high and the downturn is shallow. But what if neither of these is the case? How do you push rates deep into negative territory when people always have the alternative of holding cash for nothing?
There’s a trillion-dollar question central bankers would be hard-pressed to answer.
Consumers in Japan and parts of Europe are sending sales of safes skyrocketing.
Services offering to store cash for European firms helped prompt the ECB to start taking the 500 euro note (the “Bin Laden”) out of circulation. Big-name economists like Ken Rogoff are suddenly discovering that cash is public nuisance—which ought to be eradicated.
But so long as cash is still around, the flight from deposits plus little (or no) return from bonds equals a nightmare scenario for any bank or bank-like firm. The mere effort to take rates negative threatens to destroy the net interest margins of financial institutions: UBS analyst Jason Napier estimates that low-yield bonds alone will cut European bank profits by 20%.
The big squeeze on NIM is happening in the United States as well.
Even central bankers find it hard to be enthusiastic about NIRP. They are, after all, bankers, and they don’t enjoy seeing this bulldozer driving over the institutions they have worked for all their lives.
Hello, wealth inequality. We know that falling interest rates hurt savers. Yet it’s also true that they hugely benefit those who have already saved and possess substantial financial assets. That’s the whole rationale for QE: Make the rich richer and they will spend more, both as consumers and (especially) as society’s dominant investors. The result is a more unequal distribution of wealth.
A parallel logic holds for the old versus the young. It’s the old (whose savings are largely behind them) who have benefitted most from central bank policies. And it’s the young (whose savings are largely ahead of them) who are suffering the most. Central banks are contributing to the aging of wealth throughout the high-income world.
BEYOND MONETARY POLICY
We may soon become nostalgic for traditional monetary policy. Sure, lowering short-term interest rates to 2% or 3% was pretty weak medicine compared to what some central banks do today: pound the entire yield curve below zero and keep it there. But now we’re seeing the dark side of aggressive post-recession monetary measures: Consumers, firms, and governments are hooked on the indefinite expectation of easy money—and are traumatized by a permanently darker vision of their future.
A growing number of policy leaders are starting to suggest that monetary policy has reached the limits of its efficacy. We hear more frequent comments from Fed governors and presidents questioning the cumulative results of low rates. Just last week, BOJ backed off of its plan to dive further below zero. Few believe Janet Yellen’s insistence that the Fed still has plenty of great options the next time the U.S. economy turns south.
The problem is that any concerted move to phase out monetary stimulus may itself trigger the next downturn. Or even the announcement of such a move. Recall the “taper tantrum” that convulsed global markets in May 2013. Or the September 9 comment by Boston Fed President Eric Rosengren that low rates are becoming increasingly dangerous. The S&P 500 subsequently posted its worst single-day performance in months.
Easy money has this too in common with steroids: Doing the “right thing” by swearing off chronic use can damn near kill you.
So what now? I believe the next big thing, throughout the developed world, is fiscal stimulus. Economists at multilateral institutions like the IMF and World Bank are starting to lean that way. National leaders in Europe are leaning that way. And certainly both candidates for the U.S. presidency are leaning that way. If the global economy is still trudging forward, fiscal stimulus will be introduced in steps. If the global economy tanks, it will be introduced in massive waves.
Fiscal stimulus makes sense because monetized deficit spending (a.k.a. “helicopter money”) can do what monetary policy cannot: guarantee higher inflation. Higher inflation in turn restores effectiveness to monetary policy. What’s more, as America learned during the Reagan years, fiscal stimulus is the natural complement to monetary tightening. Even better, aggressive fiscal largesse means spending more on grand new public priorities, which means it fits the emerging populist political mood—from Brexit to Donald Trump’s candidacy to the rise of right-wing “Euroscepticism.”
You can feel it in the air. It’s coming.
- Central banks worldwide have implemented ZIRP, NIRP, and QE to try to stimulate economic demand. However, prolonged low rates have had the opposite effect on spending, causing many consumers and investors to save more and spend less.
- Monetary policy has reached its end game. Political leaders, policy experts, and the public mood are all urging a shift from aggressive monetary stimulus to aggressive fiscal stimulus. Bankers orchestrating massive bond purchases are in our past. Politicians directing massive public work projects are in our future.