Since 2007, the Federal Reserve has employed its broad mandate to enact a series of unconventional policies. While its efforts to stabilize the market during and shortly after the crisis are generally viewed in a positive light, the Fed's policies subsequent to its first round of QE (quantitative easing) have been more controversial. Years of QE and zero interest rate policy (ZIRP) have helped to stabilize the economy, albeit at levels of growth short of previous recoveries. Meanwhile, concerns about the costs and side effects of unconventional monetary policy are growing. Now, questions about the strength of the economy and markets highlight a predicament for the Fed. Having applied emergency monetary policy to the economy for years after the emergency ended, the Fed has backed itself into a corner: the next response to serious weakness must include either more QE or negative interest rates.
Janet Yellen says that the Fed is now investigating a negative interest rate policy (NIRP). Both Ben Bernanke and Stan Fischer have recently made favorable comments regarding NIRP. (While there is some question as to the legality of negative rates, there are also workarounds which would achieve the same results without technically reducing the rate below zero). In this piece, we argue that a move to negative rates represents a fundamental threat to the banking system, and by extension, to the economy at large. To treat negative rates as simply another novel policy to experiment with is worse than a bad idea. Negative rates should be removed permanently from the Fed's toolbox. If the Fed does not do so voluntarily, Congress must do it for them.
Though it is not yet clear whether ZIRP and QE have on balance benefited the real economy, it is quite clear that these policies contributed to a sharp rise in the equity market. We can't measure the effect of recent monetary policy on stocks with any degree of precision. But valuation metrics with the best long-term predictive power (e.g. Shiller CAPE, Tobin Q, Market Cap to GDP), allow us to make some rough estimates. Depending on the index and the measure used to evaluate it, fair value appears to have been at least 10% or 20% - and perhaps as much as 40% or more - below the market at its peaks of 2015. Let's compare this with how the real economy is performing. We have stable growth of around 2% per year, an unemployment rate of 4.9%, and core inflation of 2% (CPI, we have seen other measures from 1.3% to around 2.5%). Oil and other commodities have plummeted, producing low headline inflation, but also providing substantial benefits to consumers. Observers are fairly evenly divided on whether low energy prices represent a net positive to the economy; perhaps a slim majority consider them a plus. We could poke holes in the economic picture, but we could also make the case that it is quite good. At any rate, the US economy is not in crisis and has not been for some years.
The past weeks have witnessed a period of market turmoil resulting from concerns about the Chinese economy, further weakness in oil and other commodities, and questions about the timing and pace of interest rates hikes, among other things. A period of relatively soft economic data beginning last fall raised concerns about the possibility of a US recession. (Strong employment numbers and somewhat stronger macroeconomic data since the beginning of the month may be starting to assuage this fear). But setting aside international issue and macro weakness, it is fairly clear that the US equity market was, at least until recently, simply too expensive given economic fundamentals (granted, one has to be careful about drawing too close a parallel between equity valuations and the macro economy, especially near term). While US market averages have corrected about 15%, it is plausible, perhaps even likely, that stocks are still overvalued, and that absent some unexpected resurgence in the broader economy, we will see more volatility, especially if recent weakness in corporate revenues and earnings persists. Stocks have always reverted to mean valuations; it is naive to think this time will be different.
Fed policy makers thus confront a necessary period of adjustment in the equity market. The problem is that any movement away from ultra-loose policy will hasten this downtrend. This conundrum is largely of the Fed's own doing. The Fed has maintained unprecedented accommodation for half a decade after the economy exited the crisis. Rules-based models highlight the Fed's tardiness in raising rates. Many applications of the Taylor Rule, for example, suggest rates should be well above current levels. (Of course, there are a number of different tweaks to and assumptions behind this model, but we have seen plausible outputs suggesting Fed rates should be 50 to 100 bps or more higher than present.) This corresponds with the common sense observation that, in an economy with full employment and somewhat sluggish inflation, savers might expect at least one or two percent on short-term money and long rates of four or five percent. Instead, returns on the safest investments stand near zero at the short end, while treasuries are nearing all-time low yields at ten years and beyond; these rates reflect another distortion of markets due to central bank policy.
If the Fed responds to a natural reversion in stock prices with more easing, the worst case is a 'doom loop' in which easing begets volatility begets easing. We have seen some initial signs of this in markets over the last two weeks. Presently, the Fed's best course of action is - nothing. It should wait to see whether the current volatility passes, as it did last fall, or whether it indicates deeper problems. Certainly, the bar for further easing of any kind should be high.
The Fed played an important role in fighting the financial crises, and in propping up the economy during the early stages of recovery. But whether ultra-loose monetary policies post QE1 provided a net benefit is an open question. True, the worst fears of economic collapse never materialized. At the same time, growth substantially lagged other post-recovery periods. There is some recent research suggesting that the net impact of ultra-loose policy on the real economy was de minimis. And it doesn't stretch common sense to imagine that growth and job creation post-2009 or 2010 might have nearly matched what we experienced had the economy simply been allowed to heal in the context of a policy of low rates and gradual normalization. But let's posit that there was a relatively substantial benefit; against this we still must weigh the costs and risks, including distorted capital flows, yield-chasing behavior, possible asset bubbles, and the inability of savers to earn decent returns. In sum, the jury has yet to pass judgment on these policies. In a recent presentation, Loretta Mester opined that we will need to wait for normalization before a fair assessment of QE/ZIRP can be made. For now at least, it doesn't seem possible to say much more.
For some time, combating deflation (or, more accurately, disinflation, as Japan is the only major developed economy which has seen any real deflation) has been the primary focus of global central banks. Central bankers are not only obsessed with preventing deflation, but they are also quite fixated on bringing inflation to an exact level on the index of their respective choosing. In the Fed's case, this is 2.0% on core PCE. A deviation of a couple of tenths of a percent is enough to induce serious hand-wringing; half a percent is sufficient to support major policy initiatives. For example, core inflation of 1.3% on the PCE presently justifies the Fed's near zero rates and a four-trillion-dollar balance sheet. One can only wonder what we would see if deflation actually arrived.
Why is the appropriate level 2% rather than 1.5% or 1.0%? We have been looking for a body of research that supports the 2% level and have yet to find it. It would behoove the world's central banks to make this information more easily accessible. The notion that the Fed, with its mantra of data-dependency, may well have pulled such a number out of thin air would damage the institution. But even if the bankers provided ample support for this number, the lengths to which they go to achieve it seem quite out of proportion. Indeed, it sometimes seems that central bankers are so desperate to preserve the 'credibility' of their institutions, that they ignore the negative consequences of their policies. At worst, they sometimes look like economic Dr. Frankensteins - in the hubris of giving life to their models they are unable to view the results with any sort of objectivity. 'Do whatever it takes,' may be an approach warranted when a monetary system is at stake, but is it appropriate when the issue is moving core CPI up half a percent? And what if the objective is meaningless in the first place?
Negative rates represent the latest monetary experiment. Let's briefly examine why this policy holds such appeal to the central banking community. Other things equal, investors prefer cash over tangible assets because cash can be invested to provide a return. When interest rates hit zero this changes. You might as well take your money out of the bank and buy that sports car now, because without any interest you will never be able to get a better one. And when rates are below zero, things become strange indeed. You had darn well better buy that sports car now - wait too long, and you'll only have enough for a bicycle. Thus, we see that in a world of negative interest rates, the relationship between the value of tangible assets is always growing relative to money. The devaluation of money as real goods are forever bid higher goes by the name of inflation. The prospect of triggering such a process sends shivers of excitement up the spine of a true central banker. Maybe it should; imposing large negative rates across the financial landscape would almost surely produce inflation, perhaps a good deal more than desired.
Unlike QE, which was associated with steady rises in equity values - at least in the US, and Japan - major markets have not fared well with negative rates. The BOJ's introduction of NIRP was followed in short order by a 10% decline in equities. With the ECB's benchmark now at -30 bps, major European indexes have seen declines of 20-30%. Conversely, Bill Dudley's recent comment to the effect that NIRP was not under active consideration was met with an immediate surge in US stocks. Right now, there may be nothing more poisonous to stocks than negative rates. Among the many reasons for this:
- Short-term funding markets may be seriously impaired.
- Savers may actually lose money on deposits and other safe investments.
- Bank runs may occur if depositors prefer cash to negative returns.
- Pension funds, insurance companies and other institutions may not be able to achieve required rates of return and/or may have to hold more risky assets.
- Financial software and systems may not be able to accommodate negative rate inputs.
NIRP has punished shares of banks around the world. Japanese banks were among the worst performers after Kuroda launched his new rate policy. The problems of Europe's banks have been widely publicized; many of them have dropped 20 or 30% just this year. Deutsche Bank (NYSE:DB), the largest in Germany, is off its high by around 70%. Of course, the problems of these institutions extend beyond ZIRP. That being said, negative rates are particularly toxic to banks. When rates drop below zero, a bank faces a dilemma. If it passes rates through to customers, it risks losing them, and perhaps even starting a bank run, but eating the spread cuts into profits. This is all the more painful in Europe, where banks are sitting on piles of QE cash, much of which must be parked in negative yielding instruments. As negative rates become pervasive, yield curves flatten and fall below zero at longer maturities. Net interest margin is obliterated, and the core lending business becomes permanently unprofitable at market interest rates. One could not devise a more perfect way to destroy a bank. The irony is that in the process of undermining the banking system, a negative rate policy undermines the very goals it was put in place to achieve. When loan profitability falls below a certain level, banks must respond to lower interest rates with higher, not lower, loan rates. This is already happening in Europe. But this may be only temporary - the core business of banks simply cannot withstand a prolonged policy of deeply negative interest rates. Much of the industry may be forced to curtail lending, or, in the worst case, fall victim to bank runs.
The ECB is now moving to eliminate the five-hundred Euro bill. Though the stated purpose of this action is to limit funds for terrorists, limiting the use of cash is one way to enforce negative interest rates, as it forces investors to keep cash in bank accounts. This policy can thus be viewed as an attempt to pave the way for deeper rate cuts. Further steps to remove cash from circulation would highlight the ECB's intent to extend NIRP, even at the expense of the basic financial rights of its constituents.
Mario Draghi, responding to a recent query on the impact of negative rates on bank profitability, stated that bank profits were not his concern. This was stunningly obtuse. Even 'whatever it takes' will not be enough to jump-start Europe's economy if its banks cannot afford to continue making loans - unless Draghi intends to create a new financial system to transmit his monetary policy.
Once NIRP becomes firmly ensconced in the toolbox of central banks, it is unlikely to disappear for some time. Admitting an approach has failed is simply unacceptable to senior central bankers. Indeed, we are not aware of a central banker acknowledging a mistake of any magnitude in the recent past. Apparently, backtracking on a policy represents one of the principal threats to 'credibility'. Witness the spectacle of Draghi asserting that his latest rate cut was not because ZIRP was failing, but because it was working so well, and that the European economy needed more of a good thing. Draghi's comments go beyond tone deaf, raising the possibility that Europe will respond to future weakness with cuts so steep they produce bank runs. There is even the specter of a massive 'doom loop' of cuts and failures triggering economic collapse. We respectfully submit that bureaucrats operating without oversight and unfettered by checks and balances should not be in a position to cause this kind of damage.
Let's end with a brief parable. Imagine a city which one summer suffered a severe fire. The fire department arrived, albeit a bit late, and extinguished it. To prevent another fire, the department decided to flood the streets. It was hot, and everyone liked the cool water, even if it made commuting a little tough. And nothing could be done about it anyway - the city council, impressed by the firefighters' performance, had granted them complete control over fire prevention measures. The hot summer was followed by a dry fall. There was a drought, and the surrounding country became drier and drier. The fire department chiefs looked up at the city buildings, played with some fire probability models, and decided that the upper floors might now be at risk. The best way to prevent another fire, they told a disbelieving council, was to flood the city to the fifth floor. Trust us, we know exactly how this will work, the chiefs said. We have Ph.Ds in firefighting science. And by the way, they added, you gave us the power to take any measures we want, and that's what we intend to do.
Soon, perhaps, our country will need to decide whether it will follow Japan and Europe in adopting negative rates. We do not believe this decision should lie with the Fed alone. Instead, Congress should remove this option from the Fed's policy menu, preferably as part of a broader measure of reforms that limits the Fed's immense and singular power over our economy.
Disclosure: I am/we are long AND SHORT INTEREST-RATE SENSITIVE INSTRUMENTS, INCLUDING GOVERNMENT BOND FUTURES.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.