Milton Friedman argued a central bank cannot peg interest rates at a low level for a long time when the unemployment rate stays below the natural rate (NAIRU). The "interest-unemployment limit" directly related to what Friedman said is the potency and the power of monetary policy. Potency and power played center stage at the recent press conference of the European Central Bank. The ECB highlighted three distinct areas of power and potency that will be of focus for global central banks going forward:
1. What is the floor on nominal interest rates?
2. How far and how long is inflation allowed to overshoot targets in the future?
3. Will "helicopter money" become the future norm?
ECB President Draghi said deeply negative interest rates would have consequences for the banking system. In other words there is a "floor" where negative nominal interest rates cause financial instability. To quantify the floor, Vice President Constancio gave some guidance. When the yield curve remains upward sloping to generate positive net interest margin and inflation adjusted Return on Equity (ROE) of 6% or higher, a negative nominal rate (at -0.4%) is not causing financial distortion.
As Table 1 shows, global banks' average ROE is 7.25% and inflation adjusted net interest margin is around 155 bps. These numbers match global average negative rate of -0.45%. At such level of negative rates, banks' profitability is not harmed such that the financial system could freeze. Specifically, Bank of International Settlements' research found for every 100 basis points decrease in short-term rates and for every 50 basis points flattening of the yield curve, the average ROE falls by a cumulative 0.6 percentage points. Based on that empirical threshold, the floor on nominal rates could go as negative as -5% before bank profitability would be at serious risk.
Source: Bloomberg, March 2016
If negative rates work, it is not unlikely that after a period of inflation undershooting, economies may enter a period of inflation overshooting. Table 2 shows historically inflation overshooting and undershooting in the major developed economies. On a GDP weighted average basis, developed economies (G10) experience inflation undershooting on average around 2.5 years. Periods of inflation overshooting are however just 1 year.
The data in Table 2 suggests what ECB President Draghi and Fed Chair Yellen call the "symmetric objective" of inflation targets: undershoots and overshoots are allowed for "some" periods of time. History in Table 2 suggests however longer periods of overshooting are not allowed. This implies if this year sees inflation across G10 economies (slowly) normalize, central banks may in the future (2017-2019) move somewhat quicker in normalizing policy rates if economies enter a period of inflation overshooting.
Source: Bloomberg. Monthly data, 1990-2016. Countries sampled: U.S., U.K., Japan, Europe, Denmark, Sweden, Norway, Switzerland, Australia, New Zealand.
During the ECB press conference, the term "helicopter money" was discussed. As ECB member Praet said in his recent interview; "Helicopter money is giving to the people part of the net present value of your future seigniorage, the profit you make on the future banknotes." Quantitative Easing (QE) was seen before the 2008 crisis as an extreme measure but it has now become the norm. If the current period of inflation undershooting proves longer than historically was the case, the likelihood of more extreme measures by central banks is high. A form of helicopter money cannot be excluded.
Despite markets questioning at times central banks' effectiveness, the recent example by the ECB shows central banks still have potency and power. Although the success of policy remains in doubt, the effects can be strong at times. The implication is that a combination of quantitative and credit easing and negative rates should see developed market corporate bond spreads converge. Indeed, Investment Grade Credit Default Swap Indices in the U.S., Europe and Japan have moved in the vicinity of 80 to 85 basis points.
Forward markets show negative rates out to 3 years and inflation forward breakevens below 2 percent at least 1 year from today. The tension between negative nominal rates and inflation expectations is likely to become greater in the months ahead when energy markets rebalance. As negative nominal rates and inflation expectations (slowly) normalize, markets will discount when the period of inflation overshooting may start.
For the time being, central banks will continue project the floor on interest rates could be lower, inflation forecasts kept below target, and more extreme measures are considered. This should keep investors wary and portfolios have to balance duration risk versus credit risk. For now credit risk gets a green card from markets, and therefore low to negative interest rates should moderately support riskier assets.
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