Luc Vallée is chief strategist at Laurentian Bank Securities.
Janet Yellen, chair of the U.S. Federal Reserve, and other members of the Federal Open Market Committee (FOMC) decided against raising U.S. interest rates on Sept. 17. The FOMC will meet again this week to reconsider. What should we expect?
The U.S. Federal Funds rate – which pretty much dictates what short-term interest rates should be – has been stuck at zero for more than eight years, even with the U.S. economy fast approaching full employment. Starting in September of last year, the Fed and other central banks around the world tried to prepare investors and consumers for imminent rate hikes.
But in early 2015, the European Central Bank launched a massive asset-buying program and injected more liquidity into the economy. For its part, the Bank of Canada lowered its policy rate twice (whereas a year ago, it had a tightening bias – that was before oil prices collapsed). Many other central banks around the world also lowered their own rates.
Tepid U.S. growth in the first quarter of 2015 had given the Fed an excuse to skip a hike in June. In September, it was lingering uncertainty over China and fears that a global slowdown could damper U.S. growth and inflation that made it hesitant.
As much as the first rate hike by the Fed was supposed to be telegraphed and accompanied by specific forward guidance (as we were told last autumn), the "Chronicle of a Hike Foretold" has become that of a hike forgone. Between September of 2014 and September of 2015, the Fed went from expecting five rate hikes by the end of 2015 to just one. And to judge by market expectations, even this lone hike now appears much less than certain.
Actually, members of the FOMC desperately want to normalize monetary policy by slowly raising rates. The Fed recognizes that any benefit from its zero-interest-rate policy has run its course and could have undesired consequences.
But fear of the impact of "quantitative tightening" on the economy is inhibiting the U.S. central bank from moving forward. The rationale is that the current financial turmoil, and even petro states needing to finance fiscal deficits (due to lower oil prices), are causing tightening financial conditions globally.
From this reasoning flows the idea that an early rate hike could have dire economic consequences, by making financial conditions even tighter. But financial conditions in many countries have already been loosened quite extensively during the past year, by the likes of the measures mentioned above and by global currency devaluations, not to mention the positive impact of lower energy and commodity prices.
Some people would also argue that the mere threat by the Fed of rising interest rates actually tightened financial conditions. But until the benign yuan devaluation last August, there were few signs of global tightening: Interest rates on bonds of all maturities were lower, credits spreads were lower, stock markets were booming, merger-and-acquisition activities were thriving and risk-taking was flourishing.
The currency event in China on Aug.10 dramatically reversed investor sentiment. And there is even some hard evidence to suggest that growing pessimism since then also adversely affected the real economy.
Moreover, even if this uncertainty promptly dissipates, others will argue that the appreciation of the U.S. dollar against most major currencies over the course of the last year has already done the job of tightening monetary conditions in the United States and of slowing down U.S. growth and inflation.
However, ultimately, if investors become convinced that the United States will no longer raise rates in the foreseeable future, the U.S. dollar will weaken and we will be back to square one – but with lower rates and more debt globally than we had last year. We seem to be locked into a sort of financial Groundhog Day, with Ms. Yellen playing the role of Bill Murray.
This raises several questions. Was last month's Fed hold-and-wait policy stance a mistake that will come back to haunt us, or the right decision given the new headwinds created by the recent tightening of financial conditions?
One might argue that if the headwinds persist, the Fed might have made the right decision. And, if they subside, the Fed will always be able to raise rates later – next October, next December, next year.The problem with this argument is that the "right" time to increase might never come.
Will "hiking at the next meeting" become the Fed's new mantra? There will always be some doubts. There will always be uncertainty. There will always be headwinds, temporary or long lasting, until it will basically be too late.
Today, free money and the Greenspan/Bernanke put (central banks will intervene to save the day no matter what) are very much alive and well. In fact, real interest rates worldwide are negative and have been more negative, and for longer, than before the financial crisis. Although we don't know what it will look like or where it will come from, another crisis is bound to develop. In the meantime, central banks are trying to make them even more negative by stoking inflation.
Let's face it – this strategy is not working.
There is so much debt today that you wouldn't be faulted for thinking that inflation is the only way out of the mess. But this path would lead us to disaster. With negative interest rates, incentives to borrow are greater than before and even lower rates would only lead to more debt.
The Bank of International Settlement estimates today's total debt-to-income ratio of developed economies is 36 percentage points higher than in 2007, and now stands at 265 per cent of GDP. In the developing world, total debt-to-GDP stands at 167 per cent, 50 points higher than in 2007; in China the ratio is 235 per cent, more than double what it was just a decade ago.
The incentives to put on carry trades (borrowing short-term at a low rate and lending longer term at a higher rate to pocket a premium) are huge and even bigger than before the financial crisis; especially as there is an implicit guarantee that short-term rates are going to remain negative or close to zero for a long time.
So what is the Fed to do? Nobody is calling for rates to become punitively high. This would, in fact, crush most investors and the economy. But rates should increase gradually and end up being just high enough to stabilize debt ratios. If total debt (government, corporations and consumers) could grow slower than GDP growth, the world we live in would gradually deleverage.
In a world where capital would be appropriately priced and allocated, overall investments should also become less risky over time. This should eventually lower the risk premium as policy rates are being raised and help keep the cost of capital stable, yet positive. In such an environment, at the beginning, higher rates would lower global growth prospects but they would force firms to make better investment decisions.
Buying back shares when interest rates are negative, like they are today, is easy, relatively not risky and great for shareholders, but it doesn't do anything for the economy. It also increases leverage and the risk to the global economy. Finally, it increases inequalities and weakens economies politically, destabilizing society.
In short, negative interest rates encourage leverage and undermine the quality of growth. As a result, it only contributes to postponing the crisis.
It takes longer for countries or state-owned firms to fail, because states can print money. And it takes even longer for big countries to fail, because they can print even more money. However, no one can escape the logic that printing money is not creating wealth. Not since former Fed chairman Paul Volcker quashed inflation in the 1980s with high interest rates did our central banks have the discipline to let the market determine rates and correct its excesses. At any signs of economic weaknesses, we ask our central banks to lower rates to push the problem forward.
The hope of policy makers is to eventually grow out of the hole we've dug ourselves into. Those are good intentions, but for that to happen, the allocation of resources in the economy would have to be increasingly efficient. And for that to become reality, interest rates would have to be determined by the market and likely be positive. A little help from central banks is not a bad idea to promote investment in a recession when investors are risk-averse, but negative real interest rates forever is not a "little" help – it's a recipe for a crisis.
The problem with free money is that it isn't just good investments that get undertaken – investments that would have needed the extra help of policy makers during a difficult period. It's also investments that should not have been made in the first place. These bad investments are now taking up valuable resources, which are no longer available to finance other, more valuable projects.
It is time for borrowers to pay for the real cost of money. Corporations have been accustomed to investing this free money in share buybacks rather than in investing in risky but productive endeavours; it's no wonder that too few productive investments are being made, that productivity is no longer increasing as fast as we would like and that jobs are scarce and pay poorly. Similarly, consumers need to be severed from excess consumption and start saving.
Positive real after-tax interest rates would go a long way toward providing such incentives. Unfortunately, we may still have to wait a while.