A board member of the European Central Bank, Benoit Coeure of France, made a strong point in a recent statement when he said, “…for the recovery to become structural…monetary policy does not suffice.”
I think he’s right. The evidence is pretty clear in the global economy today. The Federal Reserve lowered interest rates to the zero-bound after the 2008 financial crisis and interest rates are still (essentially) there eight years later.
The economy grew and is still growing, but the stimulative impact of zero interest rate policy and “quantitative easing” is questionable at best. At Zacks Investment Management, we believe business cycles are, in large part, organic – they’re going to happen anyway. In theory, extraordinary monetary policy should have given the recovery some real juice, but it didn’t. Muddle through 2 – 3% GDP growth is hardly the stuff of gangbusters expansion. It probably would have largely happened on its own.
When you look at Europe and Japan you see the same thing. Japan has been at the zero-bound for as long as anyone can remember. Additionally, both Japan and Europe are toying with negative interest rates to try and keep money from being parked at the central bank and encourage banks to lend. Still, this isn’t really happening as intended. With interest rates falling on both ends of the curve, this is resulting in reduced bank net interest margins and squeezing profits. Banks are looking for yield elsewhere and growth in both regions is barely touching 1%.
Quantitative Easing Supports Risk Asset Prices, Not Necessarily the Economy
On a theoretical basis, when you think about what quantitative easing does it makes sense why it would not be an effective tool for stimulating structural demand in an economy. With QE programs, central banks are making massive bond purchases on the longer end of the yield curve, bidding up the prices of those bonds and keeping downward pressure on long-term interest rates.
This has two effects: first is the effect we’ve enjoyed since 2009, which is that lower long-term interest rates sort of ‘force’ investors to seek yield in the equities markets. In other words, quantitative easing pushes investors further out onto the risk curve because they don’t really have any other option. You can see this fairly clearly if you track equities markets in the U.S., Europe, and Japan with central bank balance sheet expansions. They correlate pretty tightly.
The second effect is the unintended consequence: by keeping pressure on the long end of the yield curve, central banks are helping consumers by ensuring a favorable borrowing environment but hurting banks by preventing the yield curve from being even steeper. Banks borrow on the short end of the curve and lend at the longer end, and then pocket the spread. If the longer end of the curve is being artificially held down by central bank asset purchases, it hurts profits and dis-incentivizes lending.
The Biggest Fear
The biggest fear right now, I believe, is that another unexpected/unannounced crisis hits the global economy. Should this occur, central banks will have their hands tied almost completely. They certainly can’t really lower interest rates further and more quantitative easing probably won’t accomplish anything. That’s another reason why I think it makes sense for the Fed to press forward with this rate hike cycle – they need to ‘normalize’ interest rate policy again so that in the next crisis they’ll at least have this tool at their disposal. The longer interest rates hang near the zero-bound, the higher the probability that they’ll still be there when the next crisis hits.
The Bottom Line for Investors
Central banks are running low on options when it comes to monetary policy actions to boost economies. But, the real problem has been that easy, extraordinary monetary policy has been implemented alongside fiscal austerity measures and increased financial sector regulation. These are conflicting forces!
The more banks are uncertain about what rules apply, the more reluctant they are to lend. And, governments should be more thoughtful about the risks of cutting spending and raising taxes when the underlying economy is already bruised. It only hurts more. The bottom line for investors is that we do not see this as an imminent threat – underlying demand is strong enough and labor markets are firm enough to keep the global economy expanding this year. However, if central banks globally don’t start normalizing policy soon, it could become a problem down the road.