Sunday 17 December 2017

The Gospel according to Mark (and co): fighting low inflation with rate tinkering

Bank of England governor Mark Carney delivers a speech at Lincoln Cathedral in England on the subject of interest rates last week
Bank of England governor Mark Carney delivers a speech at Lincoln Cathedral in England on the subject of interest rates last week

Paul Callan

Central banks rightly view very low inflation as problematic. When low inflation is falling, or there is a belief it will fall, a weak economy can become even more depressed.

People may postpone spending, as they expect lower prices. Debtors find it more difficult to pay existing obligations, as repayments are higher in real terms (after-inflation). People may also be reluctant to take on new borrowing, for either consumption or investment.

If prices are falling, sitting on cash becomes an attractive investment, even at a zero interest rate. That is a dangerous deflationary trap which we should worry about.

An unconventional monetary tool - Quantitative Easing (QE) - has been used as interest rates approached zero. Economic circumstances required lower interest rates, but central banks found themselves trapped with interest rates already at (or close to) zero.

When QE is instigated, central banks purchase (mostly) government securities, pushing up prices, lowering longer-term interest rates and increasing the money supply.

A primary aim is to increase inflationary expectations. Higher asset prices also improve balance sheets. While the balance sheets of some consumers are boosted by these actions, deposit savers still have to endure very low interest rates.

At its January 2015 meeting, the ECB finally announced a large QE programme, becoming the latest major central bank to do so. The ECB will buy at least €60bn worth of assets a month, until at least the autumn of 2016. Importantly it will continue buying until the Governing Council "sees a sustained adjustment on the path of inflation" consistent with its inflation target.

QE had already been used in both the US and the UK. Japan is engaged in its own extremely large programme which, as a percentage of the economy, is more than twice as large as that currently envisioned by the Europeans.

In buying longer term bonds, central banks signal that they expect (and intend) that interest rates will stay low for a very long time. Their aim is that this will encourage spending, risk-taking and investment. The central banks also make it clear they view current inflation as being too low. Critically they hope that their actions will result in a rise in inflationary expectations.

Too low an inflation rate will make a bad economic situation worse, especially when there are high levels of debt. The hoped-for reduction in high debt levels has not been realised. McKinsey Global Institute reports that "after the 2008 financial crisis and the longest and deepest global recession since World War II, it was widely expected that the world's economies would deleverage. It has not happened. Instead, debt continues to grow in nearly all countries, in both absolute terms and relative to GDP. Global debt levels have risen by $57 trillion since 2007 to $199 trillion."

New approaches may be needed to deal with the accumulation of ever-higher debt levels and the risks it poses. It is widely believed that central banks cannot cut rates much below zero, because savers have the opportunity to hold physical cash and avoid the negative interest rate penalty/tax.

Confronted by the difficulties of cutting interest rates below zero, the Fed and the Bank of England were both engaged in QE in 2009. Each Central Bank referred to practical and institutional reasons for not cutting interest rates below zero. There were fears that negative interest rates might result in Money Market Funds "breaking the buck" and cause difficulties for UK building societies. If the banks are charged when depositing with their Central Bank, most are reluctant to pass this cost on to their clients, for fear of losing the customer. So they absorb the cost, which makes them less profitable and might make them even less willing to lend - clearly not the intention.

In practical terms, negative interest rates could lead savers to "stuff their mattress with cash". A zero return is better than a negative return; but holding large amounts of cash is not easy or costless and for large sums may be impractical. A king-size mattress would be raised eight to nine feet with 1bn worth of $100 bills. As well as needing a ladder at bedtime, the cost of security against fire and theft needs consideration. Spending some or all of a large amount of money will present costs and difficulties in both transportation and security.

The belief that interest rates cannot fall much below minus 0.50pc is now being tested. In response to a flood of inward-bound capital, both Switzerland and Denmark have cut interest rates to minus 0.75pc. This is worth watching very closely. Does it mean that the markets and most economists are wrong about how deeply negative interest rates can become?

Some highly respected economists, such as Larry Summers, a former US Treasury Secretary, believe there has been a "substantial decline in the equilibrium or natural real rate of interest" and that central banks may need to introduce deeply negative interest rates. Physical currency makes this difficult.

The longer that interest rates remain negative (and the deeper the level), the greater the incentive for people to hoard physical cash; yet, in advanced economies, there is no technological reason that physical cash must exist.

There is a growing body of academic works which address this. In 'Costs and benefits to phasing out paper currency', Kenneth Rogoff of Harvard University asks whether currency in paper form has outlived its usefulness.

If there was no paper currency, central banks would be freer to apply negative interest more universally.

In Europe both money-market funds and the interbank market are operating smoothly with negative interest rates. In the US, Fed Chair Janet Yellen is now on record as saying that negative interest rates are something the Fed might consider in the future. The ECB is the first major Central Bank ever to introduce negative interest rates and it has also started a large QE programme.

Across the globe most central banks are engaged in concerted effort to combat deflation through QE and/or ultra-low interest. Even with paper currency available, both Switzerland and Denmark are trying to deter currency inflows with "deeply" negative interest rates.

Interest rates look set to stay very low for a very long time. The introduction of negative interest rates is a new experiment and bears close attention. What we can say with near-certainty is that central banks are trying to create inflation and that years of low (if not negative) interest rates seem likely.

Paul Callan is Director, Asset Allocation with Investec Wealth and Investment

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