Central banks have reduced official interest rates to historically lows, either near zero (known as ZIRP or Zero Interest Rate Policy). Long term bond rates are also at historically low levels. In some parts of the world, interest rates are now negative; that is, you get paid to borrow and punished if you save.
With interest rates bounded at zero, central bankers have turned to quantitative easing (“QE”), central banks purchase securities, primarily government bonds, to inject liquidity into the financial system. The balance sheets of major central banks have expanded from around $5-6 trillion prior to 2007/2008 to over $18 trillion. In many developed countries, central bank assets now constitute between 20% and 30% of Gross Domestic Product (“GDP”). In Japan, following the Bank of Japan’s latest round of QE, the central bank’s balance is slated to reach over 70% of GDP and new purchases of government bonds are running at around 15% of GDP.
The policies target higher growth and inflation. The premise is that lower interest rates will prompt increased borrowing and expenditure driving economic activity and employment. Bank lending will increase with lower mortgage rates encouraging re-financing and boosting the housing sector.
Lower rates and increasing the supply of money have stabilised financial markets but have not provided a significant boost to economic activity. Households crippled by existing high levels of debt, low house prices, uncertain employment prospects and stagnant income are reducing, not increasing, borrowing.
Lower official rates have had less effect than anticipated on the borrowing costs of some borrowers such as small and medium size enterprises (“SMEs”) reliant on banks for funding. Banks in many countries have increased credit margins, offsetting the fall in overall interest rates.
The absence of demand and excess capacity means that low interest rates have not encouraged new investment. Larger companies have taken advantages of low rates to raise long term debt to refinance existing borrowings, to repurchase shares or return capital to shareholders. Share buybacks by US and UK companies equate to 2-3% of GDP per annum. Low rates have also spurred mergers and acquisitions activity. Companies also hold large amounts of surplus cash, reflecting a lack of investment opportunities and caution about future financial market conditions. In the US, Europe and UK, investment has declined significantly and is below pre-2007 levels.
In a November 2012 article Monetary Policy Will Never Be the Same, International Monetary Fund Chief Economist Olivier Blanchard acknowledged the problem: “On the liquidity trap: we have discovered, unfortunately at great cost, that the zero lower bound can indeed be binding, and be binding for a long time—five years at this point…it remains a fact that compared to conventional policy, the effects of unconventional monetary policy are very limited and uncertain.”
The real effects of innovative monetary policies are different. Central banks have become crucial in financing governments. Over the last 5 years, the US Federal Reserve has purchased over 50% of bonds issued by the US government. In Japan, under new governor Haruhiko Kuroda, the Bank of Japan (“BoJ”) plans to purchase 70% of the government’s debt issuance, doubling the monetary base from 29% to 56% of GDP by 2014.
The European Central Bank (“ECB”) is theoretically prohibited from financing governments directly. Instead, the ECB has channelled abundant liquidity to European banks either directly or via member central banks to purchase government bonds, which are pledged as collateral for the loans.
Announcing QE3, US Federal Reserve Chairman Ben Bernanke acknowledged that the policy, of itself would not significantly increase economic activity directly. Instead, the plan was directed at boosting house and asset prices through purchases of mortgage backed securities. Low rates mean minimal opportunity costs in holding assets, driving a switch to higher risk investments, boosting asset prices. The strategy relies on the wealth effect which central bankers hope will translate into higher consumption boosting economic activity.
Empirical evidence suggests a weak link between higher stock prices and increased consumption. The slightly stronger link between housing prices and consumption may also be compromised, reflecting the effects of a historically unique period when homeowners borrowed against home equity built up over decades to finance consumption.
Low rates provide implicit subsidies to the financial system. Lower rates reduce the cost of deposits, which can then be reinvested in low risk government bonds at a profit. Financial institutions also benefit from higher financial assets prices driven by low rates, which reduce losses on investments that fell sharply in value in the crisis. While financial institution earnings have benefitted, they have not significantly increased the supply of credit, meaning that the effect on the real economy is limited.
Low interest rates and QE policies are also designed to weaken the currency. For example, a weaker dollar helps improve America’s export competitiveness, enabling US companies to compete better in a world of lower demand. But such a policy risks retaliation in the so-called ‘currency wars’. Ultimately, every country cannot have the cheapest currency, negating the effect of such policies.
With fiscal policy restricted, policy makers have been relying increasingly on monetary policy. But its efficacy is at best doubtful.
© 2016 Satyajit Das