Lower for longer
Yesterday, the European Central Bank and the Bank of England both announced that they were maintaining interest rates at their current very low levels. Last week, the Federal Reserve did the same. As for Japan, it virtually goes without saying that rates there will remain at their current zero level and the focus of attention when the Bank of Japan meets is what other measures it might take to loosen monetary policy, given that rates are at the ‘lower bound’ – namely zero.
In theory, a central bank could pursue a policy of negative interest rates, which would require lenders to pay borrowers to borrow money. Not surprisingly, that does not occur in practice, hence the concept of the ‘lower bound’ of zero — which is where official rates are, and have been for some time, in the US and Japan. The key bank rate in the UK is 0.5% and in the Eurozone 1% — record low levels, but that still leave room for them to be cut even lower.
This extraordinary state of affairs — an environment of extremely low interest rates in the main economies of the developed world — has held sway now for some 18 months. The ‘news’, implicit in the most recent policy decisions from the central banks noted above, is that there is no sign of this changing in the foreseeable future. Analysts in financial institutions, who had been penciling in rate hikes to begin sometime this year, are being obliged to revisit their forecasts and do two things: delay the projected date when interest rates will start to rise, and also reduce the scale of the rises, when they eventually happen.
This process is generally referred to as ‘lower for longer’. As it goes on, it becomes ‘lower for even longer’ and so on, with the theme being that there is no end in sight. Indeed, there are analysts – such as at Goldman Sachs – who said as early as last year that they did not expect US interest rates to start rising until late 2011/ early 2012, and are thus well on the way to being proven right.
This policy is the subject of a lively debate — which the minutes of the meetings of the various central banks show as including some members of the decision-making committees, and which certainly encompasses the wider community of economic analysts — as to whether this policy is correct and/or desirable. But let’s bypass that and move to the implications of a situation in which interest rates are very low for several years.
The primary beneficiaries of this policy are supposed to be businesses and households, whose borrowing costs are reduced to a minimum. This should save businesses money and, better still, spur them to borrow so as to finance investments and thereby add jobs and production. The same logic, in principle, applies to consumers – low borrowing costs should spur them to spend more and thus increase demand and drive the entire economic machine.
That is what would have happened in normal times, and that is indeed what characterised the boom years before 2007. But it is not happening today. Neither businesses nor consumers are expanding their borrowing – to the contrary, they are paying down debt. Consumers are doing so because they are ‘maxed out’: they realize they have accumulated too much debt and are trying to reduce it. Businesses are not interested in investing, because the extra demand is not there to justify it – the very low capacity utilization rate indicates how much excess productive capacity already exists. As for saving costs, the corporate sector is sitting on record levels of cash and would benefit from higher interest rates rather than lower ones. Consumer credit, on the other hand, remains very expensive in most countries, because of the massive premiums lenders take from household borrowers.
Who then is benefiting from the current policy? Don’t fall off your chairs when you discover that it’s the financial sector. A situation of near-zero short-term rates and yields of 3-4% on long-term government bonds is ideal for entities that borrow short and lend long – and those entities are commercial banks and other financial institutions. They can make easy and certain profits from this structure and can thereby generate the capital they need to restore their health. The other key beneficiary group are home-owners with mortgages, who are mainly young or middle-aged.
On the other hand, it’s pretty clear who are the main losers from a prolonged period of low interest rates: it’s the people on the other side of the financial market, the savers and investors whose funds are being lent to borrowers at rock-bottom prices. These are typically retirees and pensioners, or those saving for retirement in various frameworks. The low rates of return force them into a terrible choice: either accept negligible rates of return and effectively eat up capital, or seek channels that offer higher returns, but that carry much higher risk. This large constituency will begin to ‘push back’ against the low-interest rate policy and will express itself through the political system, adding another area of tension between different population groups that the financial crisis and dislocation is generating.