Having succeeded in maintaining low-interest rates without generating inflation, central banks are far from done worrying. Their emphasis has now shifted to questions regarding financial stability. Clearly, the major central bankers now concede that we will have low-interest rates, longer than ever imagined when they were first introduced during the 2008 crisis. Once considered as an emergency measure, zero-bound interest rates are commonplace and considered “normal” throughout the industrialized world. The Fed’s turnaround from raising rates in 2017-18 to cutting rates in 2019, disguised as a ‘mid-cycle’ adjustment, has, in fact, turned out to be a recognition that ‘lower – for- longer’ will prevail indefinitely. Indeed, the ECB and BoJ never really signed on to higher rates in the future, as they both have maintained negative rates and very aggressive bond-buying programs for more than a half-decade in the case of the ECB and much longer for the BoJ. Central bankers live generally in a worried state and now they take out their worry beads as they turn their attention to issues of financial stability.

The issue of financial stability arises when sustained low rates of interest force investors to assume greater risks to meet their investment goals. Financial stability is a rather elusive measure since it involves a huge number of complex financial transactions affecting markets at home and abroad. At best, we can identify what some of the basic underlying conditions that affect a stable financial system.

First, it is becoming ever more apparent that corporate and consumer indebtedness both are a growing concern. Lower interest rates can contribute to greater economic expansion, as corporations and consumers are able to carry higher debt loads while continuing to spend. However, in an earlier blog, the writer documented that the surge in corporate borrowings did not result in greater capital investment but rather in rewarding shareholders with higher dividends and share buybacks. Viewed differently, lower-for-longer, in this instance, has not contributed to greater output; rather, the higher level of indebtedness only has introduced a greater possibility of financial instability should the system experience an unanticipated external shock.

Second, the lower-for-longer world means that investors are on the hunt for greater returns and must assume greater risks to achieve their investment targets. We have seen this in spades as the equity markets have been on a sustained forward march for nearly a decade. Even, in the face of recession worries, equities remain the preferred asset class. As the ECB put in its latest report on financial stability:

Equity and credit valuations in the euro area seem increasingly contingent on and sensitive to changes in the yield curve, whereas nominal growth and earnings play a less prominent role in explaining the equity price increases “^[1]

In a very real sense, it is not the economy but the price of money that drives the stock market. Yet, ultimately, developments in the real economy, namely, profitability, will determine equity valuations. Until then, the central banks will be setting policy more in response to issues affecting financial stability above all else.

[1] Financial Times,” Investors grapple with indefinite monetary support”, Dec. 15,2019