Central Banks: A Cycle Of Addiction

Requiem for a Dream (2000)

A 35-year Secular Trend

Two of the world’s major central banks – namely the Bank of Japan (BOJ) and the European Central Bank (ECB) – have created what is akin to a cycle of addiction to negative interest rates. Moreover, even those developed economies with positive rates appear addicted to near-zero rates. Without them, developed market economies seemingly begin to slip back into growth malaise. [1] Ben Bernanke’s 1999 critique of the Japanese central bank’s failure to act aggressively enough to stop their ‘lost decade’ is arguably one of the first seeds of the ‘do whatever it takes’ mantras now so common amongst global central bankers. [2]  These mantras’ tools include quantitative easing (QE) – also known as Large Scale Asset Purchases (LSAPs) or Permanent Open Market Operations (POMOs) – which have ultimately forced long-rates negative in much of Europe and Japan. This suppression has far longer-lasting effects on capital allocation decisions and investor behavior than traditional rates policy using temporary open market operations (TOMOs). [3]

Step-by-step and slowly over time, the BoJ and ECB followed the Swedes and eventually arrived at negative interest rates policy (NIRP). This policy was not just limited to deposit rates but QE allowed its application to longer duration risk-free (as well as to risky) assets. Similarly, over the past 35-years, the Fed also has been on a march towards zero interest rate policy (ZIRP). However, the U.S. has the luxury of far better demographics than Europe and Japan. The U.S. also has the benefit of fiscal unity, which Europe lacks, and the U.S. has the benefit of possessing the world’s reserve currency. The structural impediments to growth in Japan and Europe have arguably necessitated more aggressive monetary policy. Not all within the central bank community agree with this approach. Former BOJ Governor Masaaki Shirakawa has identified what he calls the global ‘Japanification’ of monetary policy; importantly, he argues it has failed. [4] While Ben Bernanke has since recanted the severity of his 1999 critique, it has mattered little. Once socialized, central bankers seized upon it as an excuse to become even more active economic influencers.

An Anachronism

Traditional monetary policy models are anachronistic. Despite aggressive policy measures, inflation has not met central bank targets in the U.S., Europe or Japan. The closed and static monetary policy models of the past fail to recognize that the Fed is no longer the only large policy actor. They generally assume economies are closed and not reflexively adaptive (i.e. – dynamic). To the contrary, rates markets are open systems subject to cross-border capital flows. For example, negative rates in Europe and Japan have important impacts on U.S. rates. Figure 1 shows how the U.S. 10-year regresses against the Bund (the German 10-year). The repression of long-rates in those geographies has anchored rates here. [5] Lastly, QE killed the traditional relationships between inflation and rates, and it also murdered the Philips curve. In fact, QE has created the unintended consequence of overinvestment, overcapacity and consequent lack of pricing power. Thus, the low rates QE produced have arguably caused the low inflation central banks intended it to cure.

The most extreme deployment of QE results in prolonged periods of negative long-rates, as we currently observe in Europe and Japan. The concept of negative real rates should not be offensive on its face. Negative real rates may occur when inflation exceeds the nominal interest rate. By the Fisher identity, nominal rates = real rates + inflation; thus, real rates = nominal rates – inflation. Real rates have gone negative in the past at various periods in time, and it is one reason why the Fed or other central banks have generally chosen to hike when inflation gets too high relative to the policy rate. Traditional theory holds that negative rates are inflationary. Proponents may argue that because negative real rates have historically required central banks to raise policy benchmarks to prevent inflation (as in the Volker era) that the converse is true. That is, they may argue that the use of negative rates now will create inflation later.  We disagree. Currently, in Germany, real rates = [-.3% – .9%] = -1.1%. These deeply negative rates suggest that the ECB may be profoundly concerned about renewed deflation – ironically, we believe their prescription is producing precisely the opposite of the desired result.

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