The Persistent Low-Interest Rate Regime Carries Serious Risks

There’s a policy gridlock for central banks. They must have gone too far, unassisted by fiscal relief, pulling down the level of the interest rate. And they now face some sort of a nemesis, after their initial delusion of grandeur

The former Governor of the Bank of Mauritius (BoM), Mr Rundheersing Bheenick, protested strongly each time the BoM’s Monetary Policy Committee overruled him by deciding to again and again bring down the bank’s Key Repo Rate by a majority. He even clashed with Ministers of Finance who advocated a private sector agenda to keep bringing down the country’s structure of interest rates on the assumption that it was interest rates that were supposedly preventing the private sector from undertaking further investment.

Despite successive lowering of interest rates over the years, private sector investment is refusing to pick up. Mr Bheenick used to ask the government to stop over-exploiting monetary policy for revamping the flagging economy but to use rather an appropriate fiscal policy to get the economy going. The international fashion was to keep bringing interest rates down. So, he lost the argument to the illusory belief that lower interest rates would do the trick.

Similarly, in India, Mr Raghuram Rajan, until recently Governor of the central bank, the Reserve Bank of India, refused to toe the line of political hawks seeking to drastically reduce the country’s interest rate structure, under the mistaken political view that a lowering of the interest rate would stimulate business. As former Chief Economist of the IMF, he was among the very few who had seen the 2007-08 financial crash coming well before it did, but almost no one believed in what he had to say about it.

Mr Rajan did what he had to do according to the requirements of the Indian economy but at a measured pace, rather than copying blindly the trend to go towards zero set since long by international interest rate reducers. He preferred not to seek a renewal of his term of office last September when political pressure became excessive. He has gone back to teaching in the US.

Although it was Mr Allan Greenspan, then Chairman of the US Federal Reserve Bank, who gave the signal in 2001 for a regime of falling interest rates to stand up an economy and stock markets bubbling under the effect of wayward lending by financial institutions, real interest rates have in fact been declining in the rich world for decades now. Real interest rate is the interest one gets after setting off the effect of concurrent inflation. Mr Greenspan later regretted it when “irrational exuberance”, in his own words, surrounding lending and borrowing activities led to the financial crash of 2007. There was a fatal overdrive accelerated by low interest rates.

When the financial crisis of 2007 visited the rich world (Europe, US and Japan) and the economic downturn set in firmly the next year, central banks thought they had the solution to the problem. Governments, on their part, were at a loss. Central banks in rich countries agreed to coordinate an across-the-board lowering of their key interest rates hoping that this should trigger enough demand in the economy and help it overcome the looming recession.

The catastrophe of an economic depression or deep recession was temporarily averted. This was good enough. It gave central banks confidence that they could master the situation. The reality was much harsher than playing on the interest rate lever. Halting the worse to befall on the concerned economies was one thing, but re-engineering them for growth was quite a different kettle of fish. Economies would stop falling further, yes, but they refused to pick up as the central banks had expected them to do when pressing down and down the interest rate pedal successively.

By tinkering with the interest rate in this manner, they ultimately brought it close to zero. Thus, the crisis brought about by Brexit led the Bank of England to bring down its main policy rate to 0.25%, its lowest level during the 300 years the bank has been in operation.

Proceeding in this manner, contrary to the received wisdom that savers would be paid interest on their saving, rich countries’ central banks told them (savers) they would get nothing in return, given the unmanageable economic situation. Aggravating the outrage, some of them even landed the interest rate into negative: in other words, you as a saver will have to pay borrowers interest for them to borrow your money. One can gauge the “wisdom” behind this kind of a crazy course followed by the rich-country central banks. Market normalcy was wilfully thrown overboard.

At a point in time, the central banks of rich countries saw that even as short-term interest had been brought down to as low a level as possible, yet the economy was not responding. Something else had to be done. It was found that long term rates on, say, government and corporate bonds (debt securities issued by borrowers), were still positive though very low (10-year government bonds yielded 1.6%) and investors were flocking to them and therefore not investing in the real economy – which is how they envisaged economies would pick up again, logically enough – they went on to bring down those long term rates.

By a process known as Quantitative Easing (QE), they bought and stocked up several hundreds of billions of government and private bonds from the markets, flushing equivalent huge amounts of liquidity into the system, in itself something dangerous when reversal of the process will have to be undertaken someday. Hoping that the economy would have picked up its normal growth trajectory by then.

There are massive bond holdings today in European, US and the Japanese central banks, as a result of QE. Long term rates were thus brought down. QE has stopped, in large part, but economies have not picked up. Central banks have thus reached a point whereby they have little clue of what else to do to lift up their moribund economies.

The US Fed tried to reverse course by lifting the interest rate last December after a long phase of serial declines. There is an inverse relationship between the level of the interest rate and bond prices. Thus, when long term interest rates were first taken down by the rich-country central banks acting in concert, bond prices rose because holders buy them up frenziedly, fearing a further fall in the interest rate. Should the rich-country central banks now embark on raising interest rates as the US Fed tried, bond prices will come crashing down. Investors will lose phenomenal amounts of their money in the process. Confidence will be torn apart as the conflagration will jump from one market to the next.

Bond and other financial markets are inter-connected. If bond prices crash while central banks try to lift up interest rates from their current near-zero or negative levels to restore normalcy to the savings-investment market, not only bond prices will crash. The entire cohort of financial assets will plunge. This may herald extensive economic recession as confidence takes a serious hit while the rampage is unleashed by one central bank trying to pull up the interest rate. This is the reason why the US Fed is hesitating after its first try. It fears the whole world, the US included, might take a turn for the worst.

That’s why there’s a policy gridlock for central banks. They must have gone too far, unassisted by fiscal relief, pulling down the level of the interest rate. And they now face some sort of a nemesis, after their initial delusion of grandeur in the belief that they alone held the key to economic recovery.

This dilemma must be sorted out before asset values collapse brutally. Forget the money markets which have financial assets of their own. Global financial markets host much larger volumes of financial assets: over $100 trillion worth of bonds and $64 trillion worth of stocks. Better do all we can to avoid a financial system crash of this magnitude due to government slack, leaving it all to central banks to sort out for so long! It will be difficult to navigate out of this catastrophe but navigate we should for the good of all.

Murli Dhar

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