Current Monetary Policy – The Unintended Consequences

Summary

  • The current monetary policy led to negative interest rates around the world.
  • This policy triggered negative consequences: excessive risk taking and lower consumption.
  • Developed nations should act in concert to raise rates to avoid further damage and risks.

 

Since the financial crisis, central banks around the world have reduced interest rates to very low levels and, in certain cases, even into negative territory. I believe this strategy has two issues. First, it is no longer providing the expected results and second, it has been stretched too far. In my opinion, interest rates should have been raised long ago.

Let’s take a step back. Why do central banks reduce interest rates? To put it simply, central banks lower rates to encourage spending and discourage saving, by both companies and individuals. Today I will focus on the story for individuals, companies is for another time. The simple rationale is that it is more convenient to invest and spend, for example in a house or a car, when interest rates are low. This is because low interest rates reduce mortgage or loan payments. At the same time, low interest rates discourage saving simply because the interests earned on savings decrease.

In the years after the recent financial crisis, these mechanisms led to a sustained period of investment and a reasonable rate of economic recovery. However, these mechanisms have now been overextended. Many believe that a wide range of assets are expensive and existing within a bubble that could easily burst. In a recent interview, Esther George (FED Dallas) mentioned that “a failure to keep interest rate policy in line with improving fundamentals can distort the allocation of capital toward less fruitful-or perhaps excessively risky-endeavors.” She also argued that low interest rates could spark dangerous asset bubbles and financial destabilization.

These bubbles have already formed. Londoners have to invest more than ten years of their salary to buy a house (Nationwide). This is the highest level ever and it compares with a long term average of five years. The stock exchange is no different. This year the SP500 Shiller P/E (price/earnings) ratio reached 26 (multpl.com). In the last 130 years, these levels have been seen only three times: 2004-2007, 1998-2000 and 1929. The first period led to the recent financial crisis, the second to the dot-com bubble, and the third coincided with the great depression.

As of today, individuals are in a difficult position. They can invest in inflated assets, they can save at extremely low interest rates, or they can spend. Central banks would like them to spend. However, recent statistics show that consumers are reducing their expenditure and increasing their rate of saving. In the last four quarters, U.S. personal consumption increased at an average of 0.15% (yearly). The previous years saw an average growth of 0.275% (2014) and 0.45% (2013). Consumption growth is slowing down. Savings, on the other hand, are picking up. The U.S. saving ratio moved from 4.1% in 2013, to 5% in 2014 and 5.5% in 2015 (BEA, Statista).

In my opinion, this trend is happening for two reasons. And these reasons are related to the intrinsic rationale behind why people save. There are two main drivers for putting aside savings – one is practical and one is psychological. First, people save to increase their potential future spending, for example during retirement or for a special holiday. Second, they save a rainy day fund in case of unforeseen emergencies, be it job loss, medical care, a leaky roof or a recession.

The current monetary policy influences both reasons. First, with low rates people need to save more to be able to afford the same level of future consumption. Your future savings just are not worth as much as they used to be. Second, the prolonged monetary policy of low interest rates sends a message of negativity. This, in turn, negatively influences our perception of the economic situation. The U.S. economic sentiment (how Americans perceive the economic outlook) recovered significantly from 2009 to 2014, but from the end of 2014 it started to deteriorate (Gallup). Obviously, if people are less optimistic about the economy and the size of their future pension pot they tend to consume less and save more, to protect themselves from potential future downturns.

Therefore, after many years of extreme monetary policy, asset prices have skyrocketed and consumers, instead of spending more, are increasingly saving a larger portion of their income. Not only are monetary policies becoming less effective, they are also becoming counterproductive.

Central banks should have raised rates long ago. Delaying this decision led to few benefits and increasingly significant costs. Central banks have cornered themselves. Like an addict that needs higher doses to keep going, central banks keep increasing their doses of financial stimuli. Initially they reduced rates to zero and now some banks are going into negative territory that, until recently, was considered off-limits. And, as with an addict, the longer they delay stimulus reduction (raising interest rates), the more severe the future effects will be.

In response to the currently limited impact of monetary policies, various central banks keep increasing their stimuli. This approach is wrong and rooted in the idea that if monetary policies have not delivered so far, more of the same will eventually yield results. In Japan, Australia and Europe, governors are reducing rates and expanding quantitative easing. This strategy has been labelled a “race to the bottom”. In a global world, the effect of these moves is universally perceived, limiting the possibilities of other central banks that currently seem willing to rein in their financial packages.

Today the major economies need to normalize their monetary policies through a coordinated effort. During the financial crisis central banks cooperated to limit the contagion and further economic damage. On 8 October 2008, the central banks of Canada, England, the European Union, the United States, Switzerland and Sweden agreed to simultaneously lower rates. This was a message of unity and a firm commitment to dealing with the turmoil. Today we need a similar level of coordination, but in the other direction. Without a coordinated effort it will be very difficult for countries to significantly raise rates on their own. We need all major central banks (including Japan) to simultaneously start raising rates to normal levels. The pace of change will of course need to be adjusted per country, given they are in different phases of their economic recovery – but still, rates must rise.

Extreme monetary policies distort economic decision making. We need to restore the right balance in our economies and let economic rationale be efficient, productive and selective once again. Low interest rates are leading to inefficient decisions, inflated assets prices and systemic financial risks. The current macro-economic situation does not allow central banks to raise rates at a fast pace, but policy makers need to act, sooner rather than later. If central banks won’t raise rates the economic sentiment is likely to decrease even further, leading to an increase in savings and reduction in expenditure which is likely to negatively affect stocks, especially those in the consumer discretionary sector. On the other hand, low rates will push up prices of high yield defensive stocks such as telecoms, utilities as well as non-cyclical consumer goods and services.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.



Categories: International Stocks & Other

Tags:

%d bloggers like this: