As central bankers around the world continue to implement experimental monetary policies of various kinds, the ultimate influence of which is still very uncertain, it is worthwhile taking a step back to consider the potential risks of such policies. We should also think hard about whether there may be other paths forward that could better avoid those risks and still achieve desired results. First, however, it makes sense to briefly revisit the path that led to this predicament.
The years leading up to the 2008–’09 financial crisis were marked by an incredible buildup of leverage in various sectors of the U.S. economy, as well as by a tremendous misallocation of capital toward the housing market. Indeed, from a longer-term demographic perspective, it would have made much more sense to see a housing market exhibiting modest price increases and softer building activity, rather than the boom in both that occurred in the years leading to the crisis. That is because the proportion of the U.S. population aged 30 to 44, the prime home-buying age, had peaked in the mid-1990s and was still in a meaningful decline in the precrisis years (see chart).
Yet although that demographic trend should normally have led to only modest demand for new housing (and minor price increases), growth in the availability of credit greatly expanded the home-buying population and helped drive the boom further, to disastrous results. There are many debates surrounding the reasons behind this mid-2000s credit expansion, some squarely placing a good deal of the blame with policymakers themselves — which is probably unfair, but we will leave that topic to others.
Overall, we at BlackRock think the Federal Reserve responded admirably and creatively in the immediate wake of the crisis to stabilize the economy and begin the process of recovery, and policymakers deserve praise for those efforts. But in the years since, we have increasingly voiced concern that the policy prescriptions for a time of acute crisis have overstayed their welcome.
We have been concerned that policy distortions have been producing unintended misallocations of capital that threaten to undermine the recovery and increase left-tail risk or the possibility of an extreme negative outcome for markets. Before the Fed began normalizing interest rates last December, we had been calling for such a move for roughly two years. Today, however, it is China, emerging-markets corporations and commodity-based entities that are coming undone. That has a lot to do with the transition China is attempting — shifting its economy from a manufacturing- and trade-based model to a more services-based consumer one — but it also is a product of the excessive leverage built over the past few years.
Now that the Fed’s has either ended its major unconventional monetary policies, as in the case of quantitative easing, or begun the process of slowly winding them down, as in the case of ZIRP, we find it troubling that so many market commentators have embraced the idea of negative interest rates as the next salve for market volatility and slowing growth. The European Central Bank initiated its negative rate policy for the euro zone in June 2014. Denmark, Switzerland and Sweden have also embraced the approach. But it was the late-January addition of the Bank of Japan to this policy club that both surprised many — including us — and initiated discussions suggesting that perhaps this route was appropriate in the U.S. as well. We couldn’t disagree more.
After the global financial crisis, aggressive policy rate cuts to near-zero levels were needed to reduce excess leverage and stabilize the economy and financial system. In effect, this maneuver served as a subsidy from savers to borrowers through the interest rate channel, and it made a great deal of sense, at least for a time. Negative interest rates, however, functionally serve as a tax on savers with deposits at relevant central banks, which is to say it penalizes financial institutions through lower net interest margins and, consequently, compressed cash flow. At a time when bank capital requirements and a variety of other regulatory frameworks are also depressing bank profitability, negative rates have been disastrous for bank share prices. Generally speaking, we believe that dramatically constraining bank cash flows is not a good path to take if one wants a healthy financial sector and accommodative financial conditions.
Further, because the use of negative policy rates primarily affects the short end of the curve, the tool isn’t likely to be terribly effective, even if the Fed were to consider it seriously. That’s because both banks and nonfinancial corporations are borrowing much farther out on the curve these days — and don’t borrow anywhere close to the overnight fed funds borrowing rate — and the financial crisis rightly exposed the risks of overreliance on short-term funding markets.
Some suggest that negative policy rates are primarily intended to competitively devalue a currency, which would appear to aid export sectors. We at BlackRock believe, however, that this path often leads to counterdevaluations and other retaliatory measures, which could be bad for global growth prospects overall. Finally, negative rate policies might lead to dangerous hedging dynamics that could effectively remove productive capital from the financial system, rather than add to it. The intended goal of negative rate regimes — to get banks to lend money out to economically productive projects upon which they can earn a decent return — does not appear to be a consistent or long-lasting result of the policy, and the risks to financial stability, in our view, would far outweigh whatever meager benefit might exist short term.
If negative rates are not the answer to a possible deterioration in economic growth or to further financial instability, then what are potential solutions? Our chief concerns regarding economic and financial stability today are the global economic headwinds and market volatility stemming from capital flight and currency devaluation risk in China and, even more important, the rapidly rising cost of debt and capital for the corporate sector, which has effectively raised the bar for CFOs making long-term expenditure commitments. In other words, it could lead to significant retrenchment in capital spending and hiring. We thus find ourselves in the unusual situation in which it’s possible to imagine the Fed, even in the midst of a slow rate-hiking cycle, reengaging in quantitative easing or extending U.S. dollar swap lines, particularly if a dollar-funding crisis hits a major trading partner. And given our concerns, quantitative easing, which both dulls market volatility and can influence the long end of the curve, where companies are actually funding themselves, could smooth that slow process of rate normalization and help support global liquidity needs.
Still, all these prospective solutions apply solely for economic deterioration much worse than we have witnessed so far. In a world in which central banks appear far too quick on the trigger to engage in rescue polices for markets, we suggest that the best medicine for these times might just be a pause to these historically aggressive — and in many cases untested — policy moves, to give economies and markets time to structurally adjust to a less stimulated environment. Of course, the fiscal channel is much more important today for improving growth prospects, even if it is politically difficult in many countries. The stakes are high here. Further misallocations of capital could potentially leave future generations with lower levels of growth and demand, and could well result in very dangerous, shocked outcomes.
Rick Rieder is chief investment officer of global fixed income for BlackRock in New York.
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