September 05, 2019
Last weekend I came across some academic studies on central banks and interest rates. While dense, summations in the studies do help us, and presumably policymakers, glean some key insights into the global economy.
Part of the reason I pursued a deeper dive into these issues were my own persistent questions after the U.S. Federal Reserve meetings in Jackson Hole, Wyo. last month. Some of the speakers who are considered hawkish are pushing back on the premise that another cut is necessary.
The current economy has consumer strength but lacks business investment. However, business leaders are vocal that the reason they are holding off on investing is not that interest rates are too high. Their reluctance stems from a lack of clarity about the future, particularly concerning the U.S. trade war with China.
One study by two economists at Princeton introduced a fascinating new concept. They described the “reversal interest rate,” defined as “the rate at which accommodative monetary policy 'reverses' its intended effect and becomes contractionary for the economy.” It's one thing if lowering interest rates does not necessarily help the economy grow by spurring business investments and consumption. It is quite another for a rate to be so low that it actually hurts the economy.
The way this could happen is via the banking system. When interest rates are low it is hard for banks to make money on client deposits, and if low rates are not spurring more loan activity, that side of the business is not doing well either. This has become a particular problem in Europe and Japan.
Another paper surveys all the tools that central banks have been using for the last decade since the financial crisis. Part of its findings are that quantitative easing, where central banks buy government bonds or other assets to create liquidity, would typically be more effective than negative interest rates, but that such a monetary policy comes with additional risks that intensify the longer the practice is in use.
My View: Earlier this week I heard a couple of commentators discussing the idea of a Bretton Woods for interest rates. The original 1944 Bretton Woods agreement set up a structure among the U.S., Canada, Western European countries, Australia and Japan to govern currencies and prevent currency devaluation. That agreement lasted until 1971. Currently, it is clear that U.S. rates are being pulled down by other countries' yield structures. The idea today would be to coordinate interest rate policy among major economies to limit the spillover effects from low and negative interest rates. Unfortunately, I am not hopeful we will get that coordination.
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