I’m a big fan of the original Winnie the Pooh stories. One of my favorites is when Pooh gets too much of a good thing, in his case honey, and gets stuck trying to exit Rabbit’s house. While most of us understand the idea of “too much of a good thing” when it comes to food, we don’t apply the same lessons when evaluating monetary policy. Yet there is solid evidence central banks aren’t delivering higher growth and may be undercutting their own mission by cutting rates too far.
Success (Or Lack Thereof)
Since the financial crisis of 2008, investors have welcomed rate cut after rate cut. The cuts were welcomed when the goal was to lower the cost of borrowing, when it was to decrease savings, and when it was to depreciate the currency.
But the results of all those rate cuts have been found wanting. The United States, Japan and Europe continue to struggle with low rates of growth. The U.S. hasn’t achieved 3% growth since 2004. The European Union seems stuck below 2%, and Japan is even lower. Emerging market economies aren’t picking up the slack, and the world still lacks sufficient growth.
Spurring growth seems beyond the capability of central bankers. The initial cuts were necessary – rates needed to go lower – but insufficient. At this point in the cycle, it is quite possible that the low rates are undermining growth in some ways and introducing economic risk. Undermining lending, reducing assets available for lending, and making inflation harder to manage are three negative consequences of very low rates.
Extremely low rates undermine savers and banks. When my son opened his first savings account a number of years ago, the banker stated that if he put $100 in the account and it earned 5%, he would have $105 a year later. I’m not sure the banker appreciated my pointing out the example had an interest rate around 40 times the actual rate, and it only got worse as time went on. Today, some countries charge people for their savings by paying negative rates.
Bill Gross, portfolio manager at Janus Capital Group, said in an April investment outlook that these cuts are seemingly logical, but are “not working very well because negative interest rates break down capitalistic business models related to banking, insurance, pension funds, and ultimately small savers. They can’t earn anything!” Extremely low rates remove the incentives banks have to pursue new business and the new loans central banks encourage.
Reducing Lendable Assets
Negative interest policies encourage savers to keep their money in cash rather than put it in the bank. If my son was faced with the choice of keeping the $100 at home or putting in the bank, and, after one year, having $99.50, he would keep the money at home. But money at home has no velocity or productive use, it just sits there. Negative rates also signal economic challenges in the future, decreasing the desire for risk-taking.
Brian Wesbury, chief economist at First Trust, points out negative rates have generated demand in the economy for one product: safes. According to Wesbury, “there is a shortage of safes in Japan as consumers try to get cash out of banks where they may be charged interest, instead of receiving interest, in the future. At the margin this is happening in Europe as well. When people hold more cash, banks have fewer deposits, so the idea that these negative interest rates will force banks to lend and expand the money supply is suspect.” Inflation Struggles
Based on the first two points, the effect of negative rates may be to deter growth and reduce inflation. If the economy heals in spite of central bank policy and begins to create inflation, then the banks must raise rates. But the low rates have created an environment where a rate increase may be destabilizing. This leads us to the third challenge: Banks will struggle to control inflation effectively.
Michael Ashton, principal at Enduring Investments, points out that uniformly low rates provide little incentive to move money to higher-yielding opportunities. As rates rise, savers will be more focused on maximizing the value of their cash and putting cash into the system. Banks will be willing to lend. Thus the early interest rate hikes will likely increase economic activity (and inflation) when they are supposed to be slowing it down. Higher unexpected inflation increases the risk of a market shock and reduces the value, directly or indirectly, of many investments.
Central banks condition investors to believe they are coming to the rescue, leading investors to take on additional investment leverage that will unwind painfully. Because inflation may increase during the initial hikes, rates may have to increase quickly, pushing markets lower.
A Balanced Approach
Ongoing efforts by central banks to save the economies aren’t working, and they create an illusion of action that pulls pressure from politicians to make needed reforms, such as creating incentives and laws to keep baby boomers working. If these reforms had been made in 2010 or 2011, we could be reaping the benefits of them now.
The alternative is the admission, at a great moment of difficulty, that the cuts have been too much of a good thing and need to be undone. This is what happened to Pooh. He went on a week-long diet until he had shrunk enough that Christopher Robin, Rabbit, and all Rabbit’s relatives and friends, were able to pull him out. Better to have stopped eating the honey earlier.