September 05, 2019

Fresh Insights on Use of Economic Tools

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.

The information in this report was compiled by the staff at City National Bank from data and sources believed to be reliable but City National Bank makes no representation as to the accuracy or completeness of the information. The opinions expressed, together with any estimate or projection given, constitute the judgment of the author as of the date of the report. City National Bank has no obligation to update, modify or amend this report or to otherwise notify a reader in the event any information stated, opinion expressed, matter discussed, estimate or projection changes or is determined to be inaccurate.

This report is intended to be a source of general information. It is not to be construed as an offer, or solicitation of an offer, to buy or sell any financial instrument. It should not be relied upon as specific investment advice directed to the reader's specific investment objectives. Any financial instrument discussed in this report may not be suitable for the reader. Each reader must make his or her own investment decision, using an independent advisor if prudent, based on his or her own investment objective and financial situation. Prices and availability of financial instruments are subject to change without notice. Financial instruments denominated in a foreign currency are subject to exchange rate risk in addition to the risk of the investment.

City National Bank (and its clients or associated persons) may, at times, engage in transactions in a manner inconsistent with this report and, with respect to particular securities and financial instruments discussed, may buy from or sell to clients or others on a principal basis. Past performance is not necessarily an indication of future results. This report may not be reproduced, distributed or further published by any person without the written consent of City National Bank. Please cite source when quoting.