Macroeconomic policy hits the wall

Perspectives

Macroeconomic policy hits the wall

Are negative interest rates the “new normal”?

Official interest rates in the United States, Japan, UK and the euro area are close to zero or already negative. How long can this continue and what are the consequences?

Low interest rates arose due to “quantitative easing” (QE), the policy whereby central banks buy financial assets, such as bonds, in exchange for money. As a result, asset prices rise and returns tend to fall, a phenomenon that we have witnessed over recent years. The emergence of asset bubbles is a secondary effect of quantitative easing, leading in turn to a worse distribution of wealth.

Negative rates will exacerbate this situation. In addition to accelerating the move to riskier assets in search of return, negative rates on government bonds will also drive an increase in public debt. In June this year, the yield on 30-year Swiss bonds moved into negative territory, marking a new record as this was the instrument with the longest-dated maturity yet to do so (Chart 1). The result is that we have entered uncharted territory and an unsustainable situation.

A return to normality - with interest rates in the industrialised countries returning to the average rates seen in the second half of the 20th century - would require a massive downward revaluation of financial assets and of property. Central banks rightly fear the effect that higher interest rates will have and are trying to avoid them for as long as possible. But by postponing the correction, they are making matters worse.

Monetary and fiscal policies have run out of options

With interest rates at historic lows and public debt at critical levels, the conventional policy measures of monetary and fiscal stimuli have reached their limits. In many countries, private debt, too, is close to becoming unsustainable. Steps to promote more free trade are also confronting obstacles. The Brexit campaign in Britain, the presidential election process in the United States and political opinions in a number of European countries clearly show a surge of populism.

In addition, international political tensions are on the rise. Relations between Western countries and Russia have hit a new low, while China is busy asserting itself not just commercially, but also in the monetary and military domains.

For financial investors, there are no safe havens. Most of the so-called BRICS-countries, primarily Brazil, have disappointed as the potential new growth engines of the world economy. The euro area is hindered by the weakness of its southern member states, including Italy, which is in addition going through a banking crisis. It is up to Germany to accumulate, almost single-handedly, the surpluses needed to balance the trade deficits of other European countries.

The United Kingdom’s proposed exit from the European Union has introduced further grounds for concern. For years to come, uncertainty is likely to hamper any substantial economic recovery – not only in Britain but throughout the European Union.

A gigantic amount of international liquidity, created by quantitative easing, is desperately seeking returns. Much of this financial capital sits in pension funds and life insurers, and a large share of the population depends on the returns on these assets to fund them through retirement. Because low interest rates favor the financing of debt, they represent a huge burden for savers and, in the long run, for tax payers. As the positive effect of low interest rates on the valuation of stocks may eventually diminish in the future, returns on financial market assets will come under even more pressure.

Monetary and fiscal policies have run out of options. As a sign of their desperation, macroeconomic policy authorities have begun to discuss even more extreme measures (e.g. helicopter money or the abolition of cash), despite the fact that their previous unconventional policy measures like QE have failed to bring about a solid economic recovery.

Further plans to extend the central banks’ programme of purchasing financial assets on the open market beyond high-quality government bonds, will erode trust in the current monetary system still further; it seems that low and negative interest rates are here to stay for a long time.

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