We’re not talking about the limbo dance here, but central bank rates around the world. After (not-so-super) Mario Draghi’s bazooka last week, I decided to write a quick note about what’s going on with rates, and what are the potential pitfalls.
Why are rates important?
The interest rate is the main tool central banks have to influence the economy. Rates are used along with banking reserves and open market operations to expand or contract the money supply. If an economy is growing too fast central banks can increase the rate, making it more expensive to borrow and encouraging savings. Costs for businesses increase, earnings growth reduces, companies stop expanding, people save money or buy bonds as opposed to investing in the stock market, consumption is reduced, which directly affects sales and earnings, and it becomes a cycle by which the entire economy slows down.
On the other hand, if the economy is contracting, the central bank would lower rates, making it cheaper to borrow while encouraging investment. Unlike the previous example, costs for businesses reduce, earnings increase, companies start expanding, people invest money in the equities markets as opposed to fixed income, increase consumption, salaries grow, earnings grow, and the whole cycle repeats itself.
So why would anybody want to stop an economy from growing?
An economy can’t sustain unlimited growth. Too much growth for too long a period of time can stop and reverse abruptly creating a recession or depression (what is popularly know as the bubble bursting). Even total employment isn’t ideal. An optimal unemployment rate should be around 4%, anything lower than that is inflationary: Let’s assume for a moment that everybody in the economy is employed, if a company wants to expand, it would need to poach someone from a different company, making him a bigger offer, therefore driving prices higher, which generates inflation.
It is in the countries’ best interests that their economies grow at a controlled steady rate, and the central bankers use the interest rates as a main tool to achieve it. Historically rates have been around the 5% mark, with the exception of the high inflation periods in the 80s. Since the 2008/2009 financial crisis, central banks in the major economies started lowering rates to stimulate their economies. This was exacerbated during the Greek crisis in 2010/2011 when central banks had to continue lowering rates.
Although some treasuries have been yielding negatively for some time now, it is only recently that central banks started lowering their key rates to negative levels. Today the 10 major currencies in the world hold key interest rates at or below 0.50%: Switzerland and Sweden have negative interest rates at -0.25% and -0.50% respectively, while the European Central Bank and two others offer just 5 basis points for deposits, a further two hold rates at 10bps, and the three remaining central banks, including the US Federal Reserve are at half a percentage point. The new norm in developed economies seems to be: print a lot of money, cut interest rates and pray. But how sustainable is this?
The Fed increased the rate by a quarter percent last year, and unleashed a massive sell-off in the markets, of which they haven’t yet recovered. The markets are used to low rates, and cheap and abundant money; and it is that cheap credit that has fueled the longest bull market in global equities (7 years and counting). But what happens next?
Rock-star central bankers
I see the central banker’s job akin to that of the garbage collector in a city. You know he’s there, you know he’s doing his job because you see no garbage in the streets, and you certainly notice when he stops doing it. You don’t see him in the newspapers, giving speeches or taking air time on newscasts. That is what you should expect from your central banker.
But in recent years, central bankers have achieved celebrity status, giving opinions and speculating about what will happen, and what they’ll do about it. That shouldn’t be the case. They should leave speculation to the markets and focus on policy. Although a controversial figure, Fed Chariman Alan Greenspan was the quintessential central banker: He would give his speech regarding interest rates, attend FOMC meetings, testify before Congress, and that was about it. Despite being the second longest serving Fed chair (second only to William Martin), there is only one instance where he emitted a personal opinion on the markets: his famous “irrational exuberance of the markets” is still remembered today. Other in his place like Ben Bernanke, Janet Yellen and their European counterparts have exceeded their mandate by giving opinions and revealing their intentions ahead of time. This reduces the effect of the policies, allows markets to price them in ahead of time, and normally end in the actions not being taken as a consequence.
No room to maneuver
Central banks are running out of ammo, and Draghi’s controversial bazooka is an example of it. It is prompting experts to speculate whether they have used all their cartridges. When the next financial crisis hits (not if, when), the banks will have exhausted their options with the interest rates, and will have little or no room to maneuver. In order to protect the world economies from any future threats, the central banks should stop cutting rates, and start raising them. If that means lower returns in the stock markets for a few years, so be it. But as it stands today, they are burning their bridges and living an artificial bull market that is unsustainable under normal market conditions.
The wider effect of negative interest rates
If you have to pay someone for the privilege of lending them your money, you could be tempted to hold on to your cash and earn zero on it. There is no reason why this same logic can’t apply to the global money markets, which could lead it to dry up. We already faced a credit crunch back in 2007 and we all know how that worked out. Bottom line, negative rates sustained for a long period of time can have catastrophic effects on the wider economy curbing growth, savings, and investments.