The fear that today’s negative or low interest rates render central banks helpless in face of the next economic crisis.
This is the transcript from my podcast last Sunday, THE WOLF STREET REPORT:
There is now a new theory cropping up in Fed-speak and more generally in central-bank speak. It’s not actually a new theory. I have been saying the same thing for years. In fact, it’s not even a theory, but reality. But it’s newly cropping up in reports from the Fed and the ECB. It’s the concept of what is now called “reversal rates.”
It’s an official admission that “reversal rates” exist. The term crops up alongside the fear that countries with negative interest rates are at, or are already beyond, those “reversal rates.”
The idea of interest rate repression is to induce businesses to borrow and invest, and to induce consumers to borrow and spend, and the hope is that all this will crank up the overall economy as measured by GDP.
“Reversal rates” is the term for a situation where interest rates are so low that they’re doing more harm than good to the overall economy, and that lowering rates further will screw up the economy rather than boost it.
Central bank monetary policy, such as cutting interest rates and doing QE, takes wealth and income from one group of people and delivers it to another group of people. This is how monetary policy works. It’s not a secret. In central-bank speak, it’s called the “distributive effects of monetary policy.” The idea is that for the overall economy, this income and wealth transfer from these people over here to those people over there translates into more overall economic activity that adds to GDP.
The problem for central banks arises when too many people and businesses get screwed by these policies and when they alter decision-making in absurd ways – which is what low and negative interest rates do – to where the overall economy actually takes a hit when rates drop further.
This issue of “reversal rates” has cropped up for the first time in the Fed’s Financial Stability Report that it released a couple of days ago.
So now reversal rates are a thing. Suddenly, they’re seen as the second highest risk to the economy, after trade frictions, in the eyes of big economic players that the Fed cited in the report.
In its Financial Stability Report, the Fed says that the risks from, quote, “advanced-economy monetary policy are front and center.”
This “advanced-economy monetary policy” means ultra-low or negative interest rates and QE in effect in the advanced economies.
Given that these policies are still in place after many years, and given that the Fed has just cut rates three times, despite there not being any economic need to do so, there are now fears that the Fed and other central banks would be helpless in countering the next economic crisis.
And I quote from the Fed’s Financial Stability Report:
“Many respondents wondered whether central banks would be able to counter an economic slowdown due to already low levels of interest rates and compressed risk premiums.
“Relatedly, some contacts argued that select foreign central banks with negative policy rates were either close to or beyond reversal rates, which are the rates at which the negative effects of incremental easing – for example, weaker profitability of financial institutions or higher precautionary savings from retirees – might offset positive growth impulses.”
And the report went on:
“With regard to the Federal Reserve specifically, a few contacts highlighted the possibility that U.S. interest rates could turn negative, with potentially severe repercussions for money market funds and the municipal bond market.”
We’ve already seen that negative interest rates are terrible for banks. They destroy the core business model for banks and make future bank collapses more likely because banks cannot build capital to absorb losses.
Banks are a crucial factor in a modern economy. And they’re getting hammered in countries with very low or negative interest rates. Japanese bank stocks are down 90% from the peak 30 years ago, and European bank stocks are down 70% from 12 years ago and are now back where they’d first been in the mid-1990s.
If interest rates go very low or negative, the spread between a bank’s cost of capital and the interest rate it can charge on loans in order to make a profit gets thinner.
But banking risks get larger for two reasons:
One, prices of the assets used as collateral for loans have been inflated by these low interest rates, and when these asset prices deflate, the loans no longer have enough collateral to cover them.
And two, low interest rates drive banks into risky activities to make a profit. For example, they buy collateralized loan obligations backed by corporate junk-rated leveraged loans. As they load up on speculative financial risks, banks get more precarious and unstable. Over a longer period, this equation runs into serious trouble.
The ECB, the Bank of Japan, and the Swiss National Bank have already admitted that negative interest rates weaken banks. And they’re now trying to tweak their policies to “mitigate” the destructive effects of their policies.
In terms of the real economy, low and negative interest rates have a profoundly destructive impact in two ways: They reduce demand by depriving asset holders of income that they would have spent; and they distort the single-most important factor in economic decision making – the pricing of risk.
So how much money are we talking about?
Globally, the mountain of negative yielding debt peaked at $17 trillion with a T at the end of August. As yields have ticked up since then, the mountain is now down to a still mind-bending $12 trillion or so. Debt that has a negative yield is absurd. It turns the whole equation of borrowing and lending upside down.
In the US, there are no negative interest rates. But there is a lot of zero-yielding or ultra-low-yielding debt. One person’s debt is another person’s income producing asset – when interest rates are low, these assets produce little or no income.
In the US in total, there are over $40 trillion with a T in fixed-income financial assets, including Treasury securities, bank savings products such as savings accounts and CDs, investment-grade corporate bonds, municipal bonds, and asset-backed securities. People and businesses that hold these $40 trillion in assets, directly or indirectly, expect to earn income from these investments. And that income has gotten smashed by low interest rates.
A 2% reduction in interest rates on the $40 trillion in assets means a reduction of $800 billion in income per year. This amounts to 3.5% of GDP. $800 billion a year is a lot of money that cannot be spent.
When interest rates come down, these people have less money to spend, and they cut their spending. This includes the many retirees in the US. And it reduces demand. This has been happening in Japan for over 20 years. It’s happening in Europe. And it’s happening in the US.
When central banks, in this environment of already lacking demand, cut interest rates further, they will make the demand problem worse. In other words, these “distributive effects” no longer benefit the overall economy, but hurt it.
This is the point where “reversal rates” set in.
In addition, low interest rates do something else that damages the overall economy: they distort the pricing of risk. Risk is priced via the cost of capital. Normally, investors demand a larger return to compensate them for a higher risk.
But if central banks push interest rates too low, this essential function doesn’t function anymore. While investors and banks are taking more and more risk to make a little return, unprofitable projects get funded cheaply, thus encouraging unprofitable projects, malinvestment, misallocation of capital, and ultimately zombie projects with big losses. It means overproduction and overcapacity. It means asset bubbles that infuse the entire financial system with huge risks.
All of these factors are bad over the longer term for the real economy.
Low interest rates are supposed to support the part of the economy that benefits from debt funding, such as capital-intensive production of durable goods, building factories, and expanding production. Low interest rates also make it cheaper for companies and consumers to borrow in order to buy these goods, and this stimulates demand for these goods.
But those benefits of cutting rates further are minimal when interest rates are already low or negative, and are now outweighed by the drawbacks of low interest rates – such as lowering demand from people and businesses whose income from their investments was crushed.
This is the point where reversal rates set in. At that point, the lower the rates go, the worse the economy gets. At that point, central banks can no longer counter an economic crisis because cutting rates further and doing even more QE would just make the problem worse.
In its Financial Stability Report, the Fed lamented once again, as it had done many times before, the historically high leverage and indebtedness of the nonfinancial business sector, and the risks this debt could pose for the financial system.
And I quote from the report:
“If interest rates were to remain low for a prolonged period, the profitability of banks, insurers, and other financial intermediaries could come under stress and spur reach-for-yield behavior, thereby increasing the vulnerability of the financial sector to subsequent shocks.”
But the Fed is talking out of both sides of its mouth.
The warnings in the Financial Stability Report came, ironically, after the Fed has cut interest rates three times over the past few months, to encourage even more leverage and indebtedness. And it came after the Fed opened its vault and handed out $280 billion over the past two months in order to push down interest rates in the repo market, after they’d started blowing out.
This was an effort to bail out financial companies, such as hedge funds, private equity firms, mortgage real estate investment trusts, and banks that had taken too much risk borrowing short-term at ultra-low interest rates in the repo market to fund long-term speculations in mortgage-backed securities and the like.
This is precisely the yield-chasing risk-taking behavior that the report warned about. And the Fed just bailed out these entities and guaranteed that the market wouldn’t be allowed to function as a market with actual price discovery and risks. With this bailout, it further encouraged reckless risk-taking in the financial sector.
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