An interest rate hike to stimulate growth? Yup, it sounds counter-intuitive, but isn’t the proof in the pudding? Seven years of zero rates and a $4 trillion balance sheet and the economy is struggling to even surpass 2% growth. That’s some stimulus.
You’ve read on this site before that the Fed’s prolonged period of zero rates and its big balance sheet may now be a larger drag on growth than a stimulus to it. It would follow then that removing zero percent rates and shrinking the balance sheet may actually help growth rather than hurt it (the same is not true for asset markets).
How can zero percent interest rates be a drag on growth? Lending becomes riskier at zero rates and less profitable when the yield curve flattens. Both factors tighten credit. Zero rates also take away interest income from savers, and their benefit to borrowers loses its punch as time passes.
Bill Gross goes into greater detail in his latest Investment Outlook. Gross has been on the zero-rates-are-a-drag bandwagon for a while now. A new and notable addition is JP Morgan’s Chief Global Strategist. When even the big Wall Street banks, who tend to benefit the most from the Fed’s free money truck, are saying rates need to increase, you know the Fed is far behind the curve.
Below are a couple of excerpts from Gross’s latest and from David Kelly, J.P. Morgan’s Chief Global Strategist. Both reports are worth a full read.
Historically, central banks have comfortably relied on a model which dictates that lower and lower yields will stimulate aggregate demand and, in the case of financial markets, drive asset prices up and purchases outward on the risk spectrum as investors seek to maintain higher returns. Today, near zero policy rates and in some cases negative sovereign yields have succeeded in driving asset markets higher and keeping real developed economies afloat. But now, after nearly six years of such policies producing only anemic real and nominal GDP growth, and – importantly – declining corporate profit growth as shown in Chart 1, it is appropriate to question not only the effectiveness of these historical conceptual models, but entertain the increasing probability that they may, counterintuitively, be hazardous to an economy’s health.
The proposed Gresham’s corollary is not just another name for “pushing on a string” or a “liquidity trap”. Both of these concepts depend significantly on the perception of increasing risk in credit markets which in turn reduce the incentive for lenders to expand credit. But rates at the zero bound do much the same thing. Zero-bound money – quality aside – lowers incentives to expand loans and create credit growth. Will Rogers once humorously said in the Depression that he was more concerned about the return of his money than the return on his money. His simple expression was another way of saying that from a system wide perspective, when the return on money becomes close to zero in nominal terms and substantially negative in real terms, then normal functionality may break down. If at the same time, and over a several year timeframe, bond investors become increasingly convinced that policy rates will remain close to 0% for an “extended period of time”, then yield curves flatten; 5, 10, and 30 year bonds move lower in yield, which at first blush would seem to be positive for economic expansion (reducing mortgage rates and such). It would seem that lower borrowing costs in historical logic should cause companies and households to borrow and spend more. The post-Lehman experience, as well as the lost decades of Japan, however, show that they may not, if these longer term yields are close to the zero bound.
The Fed, the ECB, the BOJ? Stupid, they are not. But stubborn, and reluctant to adapt to a significantly changed finance based economy over the past 40 years? Most certainly. Central bankers’ failure to recognize the “Shadow Banking” system pre-Lehman proved that, and their fixation on zero bound or in some cases negative yields, with their accompanying low and flat intermediate and long term rates, confirms the same today.
It is commonly assumed that when the Federal Reserve (Fed) begins to raise short-term interest rates from near-zero levels, their actions will slow the economy. We believe this is wrong, that the relationship between short-term interest rates and aggregate demand is non-linear, and that the first few rate hikes would actually boost aggregate demand, although further hikes from a higher level could reduce it. To show this, we look at six broad effects of raising short-term interest rates: An income effect, a price effect, a wealth effect, an exchange rate effect, an expectations effect and a confidence effect. This analysis suggests that the Fed should, belatedly, begin to raise rates now, not because the economy is strong enough to take the hit, but rather because it is weak enough to welcome the help.
Jeremy Jones, CFA
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