Federal Reserve Chairwoman Janet Yellen hinted this week, following a thoroughly disappointing US jobs report, that she will not be raising short-term interest rates anytime soon, not until the economic outlook improves. In other words, easy-money policies will persist in the United States, as they will in other advanced economies. All the leading Central Banks have been setting their short-term intervention rates close to zero for quite some time. The Bank of Japan has done so since 1995. The US Fed and the Bank of England have been following since 2009. In 2013 the European Central Bank joined in, and the trend is now increasingly toward negative rates.
Low Central Bank rates push down interbank rates, so that banks can borrow cheaply from each other as well as the Central Bank. The theory holds that a reduced cost of funding spurs private-sector lending and, along with it, company investment, job creation and consumption. Negative rates mean that Central Banks charge commercial banks for holding their reserves, and the idea is that the latter will then be forced to put excess reserves to work by lending more to businesses and consumers.Alas, what seems to work so well in textbooks often has a devil of a time proving its worth in practice. And while there are some benefits from low or even negative interest rates, the pernicious side-effects tend to outweigh the pluses.
On the positive side, rock-bottom interest rates have brought down household debt service as a percentage of disposable income to its lowest since at least 1980 in the United States. More significantly, governments can borrow very, very cheaply these days and in some cases actually get paid for taking money. Yields on Germany’s benchmark 10-year bonds are skirting close to zero. Those in the United Kingdom are at all-time lows and Switzerland is planning its first sale of bonds that pay out no interest. This makes government debt loads tenable which at more normal rates might be extremely difficult to manage, such as the USD 19.3 trillion owed by the US (an amount that doubled in only seven years).
The problem is that charging little or nothing for money is skewing the whole financial system in ways that become difficult to unravel. Central Banks can pump out money and make it cheap, but they cannot determine where the cash flows and there have been all sorts of indications that the beneficiaries of the CB’s wealth transfer are not following the playbook.
There are a number of reasons why companies are not investing as expected. US enterprises are sitting on nearly USD 2 trillion in cash, yet job creation has been dismal. What Washington forgets is that the cost of credit and capital is only one variable in host of factors determining corporate investment decisions. These include increased demand and growth prospects, for instance, as frequently much more important influences.
Also, as yields from lending have melted away, so has the willingness of banks to take risks. In some cases they can earn adequate returns simply by borrowing at near-zero rates and investing almost risk-free and without effort in longer-term government debt. When they do lend to business they only do so to borrowers with the highest credit ratings and with substantial assets to collateralize the loans.
Result: While large businesses tend to be flush with cash, many of the small and medium-sized enterprises (SMEs), traditionally the main source of job creation, cannot borrow at the rates that big firms, big banks, or the government can. This hurts their operations and investment. In fact, there has been a significant slump in the number of US business startups (although on this front the increasingly hostile regulatory environment also carries much responsibility).
Overall, the flow of money to the Main Street economy has been reduced, not increased, since the cost has plummeted. Funds instead go into assets that do not produce employment, such as the stock market and paying down loans (perhaps TARP loans to lessen government oversight?). This creates asset bubbles apt to burst dangerously once interest rates start to rise again.
Low interest rates also affect insurance companies that rely on a certain, interest-based return on the money they receive in premiums to support their coverage liabilities, so premiums rise. The same holds true for governmental and corporate pension plans, foundations, trusts and the like, which have to raise contributions to make up for lower or non-existent investment returns. Low rates hurt people who live off the interest income from their savings, so they cut back their spending. When a large group of them, such as the baby-boomer retirees, reduce their spending, overall economic activity slows.
Not to be forgotten is the psychological effect, since the current environment relieves any pressure governments may have felt to go ahead with the structural reforms that are needed to mop up budgetary red ink. Furthermore, it counteracts any effort to encourage personal saving. Germany, in particular, has a long-established savings culture that has served the country well but could break if low interest rates persist.
In essence, super-low or negative interest rates skew the entire financial system to the point where it no longer functions as it should. There is something seriously wrong when most money market funds in Japan are shutting down. There is much amiss when the venerable Bank of Tokyo-Mitsubishi, in response to the Bank of Japan’s move to negative interest rates, is proposing to become the first institution to quit the 22-member club of primary dealers of sovereign debt.
There is clearly a problem when Germany’s Commerzbank is considering stashing cash in costly deposit boxes instead of keeping it with the European Central Bank to avoid interest penalties. And the system is startlingly screwed up when a government asks its citizens to hold off on paying their taxes for as long as possible -- because it does not want to wind up with expensive bank deposits, as the Cantonal administration of Zug, Switzerland, recently did.