Global interest rates are at their lowest levels in decades. This has baffled many leading economists and global fund managers. The discussion centers around deflation and the “new normal,” which has been a period defined as slow global growth and very low returns.
But is this just a temporary speed bump on the road to economic recovery and rates will begin to rise as this becomes apparent? And why has no inflation been created despite the massive global easing cycle created by every central bank in the developed world?
In a 4-part blog series, Former Federal Reserve Chairman Bernanke has explained why he believes interest rates are so low the world over. In some European countries, most notably Switzerland, Denmark, Germany, Finland, the Netherlands, and Austria have had or do have negative interest rates.
Presently, more than 2 trillion Euro worth of Eurozone government bonds trade at a negative interest rate. This comes out to more than 30% of all government debt in the Eurozone. In certain countries the statistics are even more stark. For example, in Germany, 70 percent of all German bonds now trade at a negative yield; in France it is 50%.
The chart below shows the trajectory of global 10 year bond yields since 1990:
Negative interest rates
Negative interest rates are when you give the bank or government some form of money, and over time these entities will give you back less money than what you initially deposited. For more on this please refer to my interview with Professor Miles Kimball on negative interest rates.
Essentially, the depositors are paying a bank or government to take care of their money. This is the result of a flight to safety for people who are extremely risk averse, and this typically happens on the heels of a massive recession in places where there is little to no growth (e.g. the EU).
The motivation behind this from a central bank perspective is to get businesses in particular to take loans and finance operations very cheaply in an effort to stimulate an ailing economy. A side effect is that savers are punished greatly and are exposed to risk in an effort to find yield and returns, which, in theory, is also expected to boost economic activity through the wealth effect.
Quantitative Easing (QE) by global central banks has also been responsible for the suppression of interest rates as well, which has had the same effect on risk appetite.
Inflation Expectations
It’s important to understand Bernanke’s reasoning because current Chairwoman Janet Yellen’s Fed Policy is based on its predecessor: the Bernanke Fed. The parlance for this is “Fed watching” and this is done by many in the financial sphere to get a read on capital markets based on the actions of the Federal Reserve.
Bernanke explains that low interest rates can partly be explained by the rise and fall in the rate of inflation. The reason for this is simple: when inflation is high, investors want higher yields “to compensate them for the declining purchasing power of the dollars with which they wish to be repaid.”
In other words, inflation expectations affect interest rates as the chart below shows:
It is well known that the Fed is the primary determinant of short-term interest rates. This is one of the monetary tools the Fed has at its disposal and Bernanke candidly admits that Fed policy can also influence inflation and inflation expectations (allegedly) over the longer term (10-30 years). He argues that this matters not and that real interest rate is the one matters from a capital investment standpoint, which is inflation adjusted (market interest rate- inflation rate. However, the Fed doesn’t control the real interest rate (Bernanke’s opinion), what does are: growth prospects for and real growth within the economy.
What the Fed does is use its best estimate to find an equilibrium rate (or in plain speak “guess”) so as not to choke off economic growth or recovery on one side, and on the other side make sure the economy does not overheat and crash.
This is balancing inflation and deflation, which in recent history, the Fed has not “estimated” right. According to Bernanke:
“[T]he Fed cannot somehow […] leave interest rates to be determined by ‘the markets.’ The Fed’s actions determine the money supply and thus short-term interest rates; it has no choice but to set the short-term interest rate somewhere. So where should that be?”
Therefore, his answer is to set it at the equilibrium rate, whatever that equilibrium might be.
Secular Stagnation
The US Federal Reserve has 2 mandates:
- to achieve full employment (a number they determine);
- keep inflation rates low and stable (2% is the target rate here).
Despite all the monetary tools at the Fed’s disposal the inflation target rate has not been achieved as the chart below shows.
Bernanke believes this is due to slow economic growth, low inflation, and low real interest rates, which generally defines secular stagnation. Yet, he believes that this is not so. Larry Summers states that “the essence of secular stagnation is a chronic excess of saving over investment.”
As this chart shows and Bernanke states since there is a Zero Limit Band on interest rates (insert definition here) meaning nominal interest rates can not fall below zero and real interest rates can not fall below -2.
Bernanke seems to think that negative interest rates are a temporary phenomenon, which can be properly managed without causing giant misallocations of capital for the reasons noted in the beginning of this article.
His argument is that secular stagnation can’t just occur in one country but can only occur if there are low returns globally. In other words, money will go where it needs to find returns and that there are places in the world where proper returns can be achieved. Perhaps this could work when the entire planet is involved in a giant easing cycle, but time will tell if that is enough to jumpstart the global economy.
The Global Savings Glut
Bernanke cites the “global saving glut” as another reason for low interest rates. This is determined by global flows of savings and investment. He stated:
“My conclusion was that a global excess of desired saving over desired investment, emanating in large part from China and other Asian emerging market economies and oil producers like Saudi Arabia, was a major reason for low global interest rates.”
This glut, according to Bernanke is caused by government policy decisions. Bernanke believes that these policies should be reversed so as to cause savings to be put into investments.
Referencing China’s move away from an export economy and the continued buildup of foreign reserves in Asia as well as low oil prices, Bernanke notes that this has put global savings into a downward trend, which is a cause for optimism. He also added that the international community should oppose countries whose national policies promote current account surpluses.
Term Premiums
Lastly, Bernanke looks at longer term interest rates to understand why interest rates are so low worldwide. According to Bernanke, there are three components which determine yield:
- expected inflation;
- expectations about the future path of short term interest rates;
- a term premium.
As has been stated, the first two components are expected to remain low due to low expectations of global growth. Since short term rates are expected to remain low, Bernanke believes this causes longer term rates to come down as well.
Bernanke focuses on term premiums in the 4th part of this series and defines them as “the extra return lenders demand to hold a longer-term bond instead of investing in a series of shorter term securities.” Due to time risk, (the cost of holding longer term bonds) longer term yields usually pay more than short term yields, which means their term premiums are higher.
There are 2 key determinants of term premiums:
- changes in the perceived risk of longer term securities (yields have been coming down due to a perception of less inflation risk);
- changes in the demand for specific securities (investors have been buying more longer term bonds so price has gone up and yields have come down) relative to their supply.
As the chart below shows, this has caused yields and term premiums to both come down. With low inflation, low inflation expectations and global easing this is what should be happening according to the former Chairman.
Bernanke:
“The low level of term premiums in turn reflects a number of factors including: minimal investor concern about inflation; relatively low uncertainty about the likely future course of interest rates, a strong global demand for safe, liquid assets; and quantitative easing programs by central banks.”
Conclusion
The question is should we believe Chairman Bernanke that this is just a temporary headwind on the road to global recovery or have we reached a longer period of slower growth and economic malaise?
A funny thing about expectations, especially ones where the Fed and most investors are positioned on the same side, is that they usually have unexpected results. Surprises happen all the time. The Central Bank has a history of fueling bubbles with loose monetary policy and leaving interest rates at low levels for too long so why should this time be any different?
There have been enormous misallocations of capital caused by non-stop global easing for years alongside negative to low interest rates. If economic malaise continues, rates should remain low and negative on a global scale.
But if Bernanke is right and the economy is about to turn the corner, the low expectations of inflation combined with monetary irresponsibility could bring about unintended consequences, such as a pick up in inflation faster than anyone thought possible, which would stonewall a global recovery and usher in the next recession.
