Key Takeaways
Many central banks are unable to lower interest rates much further, and they’ve been increasingly using so-called unconventional policy tools such as quantitative easing and forward guidance to achieve their objectives
These efforts have hurt income-seekers frustrated with low yields, equity investors grappling with elevated valuations, and investors facing increasingly expensive “alternative” asset classes like infrastructure and real estate
Central banks are walking a fine line: they don’t want to be too aggressive for too long, but they also don’t want to pull back too soon and risk another downturn
Concerns are rising about how central banks can influence the business cycle and markets with the same effectiveness they’ve historically shown; unless central banks find a way, their decisions could become less important to investors but we are not there yet
After several decades of ultra-low interest rates around the world, central banks have nearly exhausted their ability to use rate cuts to steer inflation and the business cycle. The Bank of Japan and the European Central Bank have been at the so-called zero lower bound for years, with interest rates near or below 0%, and some market watchers also think there is a growing possibility that the US Federal Reserve will approach this boundary.
The primary issue with rates this low is not only that they leave central banks with little scope for additional cuts when the next downturn hits, but that low rates are making investors pay more for sufficient cash flows from bonds, stocks, infrastructure and other asset classes.
With rates so low, what’s left in the central-bank toolbox?
Given the current environment, central banks have increasingly turned to unconventional policy tools such as these:
Balance-sheet expansion via asset purchases (known as “quantitative easing”), which mainly involves buying government bonds to bring down interest rates and entice investors to take more risk. Central banks can also provide long-term liquidity to commercial banks to create an environment where the credit supply is plentiful which is what the European Central Bank (ECB) aimed to do with its targeted long-term refinancing operations (TLTRO).
Forward guidance via communications that promise low interest rates until a certain date in the future, or until certain conditions are met.
Negative rates that ignore the zero lower bound and more aggressively discourage saving.
Given that many of these tools are still being used to fight the recent economic slowdown and sliding inflation expectations, we expect unconventional measures such as these to stay with us for some time or be re-introduced at the next downturn.
Yet we have doubts that these tools will be enough. Some of them have inherent limits and almost all have significant negative side effects (read more here). For example:
Too low or negative rates usually lower banks’ profitability, because of the shrinking difference between the lending rate and deposit rate. In other words, the amount banks can charge for loans has been declining more than the amount banks pay depositors which has been approaching a “natural” zero boundary. This is a problem because a weak banking sector is less able to supply credit to small enterprises and households, ultimately hurting economic growth.
When central banks own a high share of their local government bond markets, liquidity can dry up because there are fewer securities on the market.
As central banks get caught up in financing government spending by buying government debt, their independence is threatened which could theoretically hurt the credibility of the currencies they issue.
Central banks are conducting thorough reviews to find more options
Given these challenges, policy reviews are underway at many key central banks, including the ECB and Federal Reserve – with the Fed potentially announcing its results in the first half of 2020.
One of the options central banks are considering is modifying their inflation targets to fight the self-fulfilling prophecy of low inflation expectations. When people believe inflation will be lower than expected, workers may not look for higher wages and companies may not raise prices. As a result, actual inflation could fall, which would result in lower nominal interest rates (the sum of real interest rates and the rate of inflation). The problem with this is that ever-lower nominal rates put central banks at a continually lower starting point from which to operate when the next downturn hits. However, if central banks found a way to stabilise or increase inflation expectations, then they would be able to set higher nominal interest rates – which would get them farther away from the zero lower bound and give them more room to manoeuvre during the next crisis.
Here are some of the ways central banks are thinking of changing how they view and address inflation:
Communicate average inflation targets. Under this scenario, central banks would be comfortable overshooting inflation targets for a time after undershooting them or vice versa. What matters would be the average inflation level over a predefined time period. The hope is that this approach would stabilise inflation expectations and would help avoid entering a deflationary spiral. We consider this to be central banks’ most credible option, but they would need to prove they can overshoot inflation and recent experience has shown that meeting current inflation targets has been difficult for them to do.
Use more monetary stimulus to fight low inflation. Central banks may decide to do more than change how they communicate inflation targets. Rather, they could also “walk the talk” and fight the recent phenomenon of too-low inflation by applying more monetary stimulus especially at mid and late phases of the economic cycle to make up for previously undershooting inflation targets. This carries the risk of overstimulating the economy, and would likely only work sustainably if central banks overcame their inability to boost inflation within a reasonable period of time.
Switch to price-level targets. This would involve applying even more aggressive stimulus in case a price-level inflation target was missed, since price-level indexes increase over time relentlessly.
Raise the inflation target. If central banks could do this credibly and if the economy responded, for example with businesses paying higher wages central banks could increase nominal interest rate levels. However, we think this could undermine central-bank credibility – not least because of doubts central banks could reach higher targets. This option could also open Pandora’s box: once inflation targets are raised for the first time, why not do it again and again? Following this path could seriously devalue a country’s currency and lead to uncontrollable inflation.
Continued low rates will likely have significant implications for investors
If interest rates stay at abnormally low levels for longer, the hunt for yield will continue. With yields low and prices high in many fixed-income segments, investors can expect lower returns for years to come and may need to take additional risks to find sufficient returns.
Ultimately, low rates will continue to affect long-term returns in more “risky” asset classes as well, since all of those include an element of a now-negligible or negative “risk-free” return.
The longer rates stay low, the more demand there will be for reliably recurring cash flow streams from infrastructure and real estate. Their already elevated valuations could get even more expensive.
Within equity markets, low discount rates structurally favour high-duration growth stocks and reliable dividend payers. However, valuations are already high in those market segments, so investors will need to carefully assess their opportunities. Active managers may be better prepared for this task.
A rising danger that central banks will lose credibility by doing too much
If the dominance of monetary policy is one day replaced by a markedly more expansive fiscal policy meaning some combination of higher government spending and lower taxes central banks may be asked to “underwrite” this spending by buying debt. Over time, that could mean higher inflation rates, interest rates and bond yields. Under this scenario, investors may want to turn to short-duration fixed-income assets, and look for a renaissance of value stocks in equity markets.
If central banks overstimulate economies in the pursuit of hitting inflation targets, financial stability risks would rise. This probably also means rising risk premia to compensate investors for taking greater credit, inflation, duration and liquidity risks and more generally volatility. At the same time, the hunt for yield would become less pressing and forced risk-taking by investors could be unmasked. The risk-taking capabilities of less experienced credit investors may be stress-tested which could signal a damaging phase for rather illiquid credit assets.
Ultimately, if central banks were to lose their credibility by taking steps the market deemed too drastic, a crisis currency like gold might attract significant investor demand but we are not there yet.