Negative interest rates, mountains of debt and the future – some questions and answers
We are living in strange times. Central Banks are buying trillions of dollars of bonds in quantitative easing programs leading to lower interest rates. Governments are borrowing trillions to support the economy. It is natural to wonder how that plays out longer term. We share our thoughts on some of those big questions.
One of the real pleasures of working in the same part of town for the past fifteen years is that you get to know people around town. I love hearing their stories and chatting about markets or the economy. I always learn something new.
An overwhelming theme of recent conversations is the almost surreal world we are living in. Governments are borrowing trillions, US$11trillion by our last count, and central banks, in quantitative easing programs, have bought more US$10 trillion of government and corporate bonds, since the coronavirus crisis hit.
Dependence on the state is becoming increasingly ingrained and the unintended consequences are piling up. This raises a lot of very natural questions. What does it all mean? Is this something we should be worried about? What are the long term consequences? And what effect might this have on how you build your wealth?
These are weighty and difficult questions. We share our thoughts on a few of these below. It does mean a longer than usual article but I hope it’s useful.
Given I can’t catch up with all of you for a coffee in Takapuna (although feel free to pop by anytime) if you have any questions you would like us to cover in future articles please email me at [email protected] and we will do our best to cover them.
We are living in unprecedented times. There is a lot for all of us to get our heads around.
Does it make sense that the government is propping up the economy?
As the coronacrisis has unfolded Governments were faced with an almost impossible set of choices. Do they manage the health consequences of the crisis, impose harsh lockdowns and at the same time harm the economy? Do they borrow to support business and workers, or face an even larger wave of business failures and rapidly spiking unemployment?
Getting every nuance of these decisions right is impossible, but we are firmly of the view that governments, and central banks, around the world have made the right choice upping spending, lowering interest rates and supporting the economy through an incredibly challenging time.
The alternative scenario of even more widespread business failures and what could have morphed into a financial system meltdown would have imposed a much greater longer term cost on the global economy.
The better choice between two evils was made.
But there are consequences to those choices and there will be winners and losers both at a corporate level and for individuals. That is an unfair, but unfortunate side effect of the speedy actions needed in what have been desperate times.
Surely the government can’t just keep on borrowing money
For many of us, life has a rhythm. You get a job, find a partner, have children and get a house, not necessarily in that order! Then you spend the rest of your life paying your mortgage off. Debt hangs over our heads like a lead weight, the word mortgage literally means death pledge.
The government isn’t like us. It doesn’t grow old and it doesn’t have to pay off debt by a certain date. Debt accumulated in the past can be refinanced and paid off with new debt. And debt can grow over time.
That doesn’t mean there aren’t limits to what a government can borrow. The primary limit is provided by the size of the economy. As long as debt relative to GDP stays within reasonable bounds it can stay at elevated levels for very long periods of time.
In took, for instance, 45 years for the United States to effectively repay debt accumulated during the Second World War, with debt relative to GDP only falling to pre-war levels in 1985. That is a very long mortgage!
Accumulating government debt in a crisis like the one we face is not a bad thing and it is manageable.
What does concern me is the potential to “waste” this borrowed money by frittering it away on bad investments, propping up failing companies and not investing in the productive capacity of the economy.
It would also be bad for governments to fall too in love with notion of ongoing borrowing and to not have a credible plan to slowly reduce debt, at least relative to GDP, when better times return.
Will all this borrowing and quantitative easing cause inflation?
In the global financial crisis we were introduced to the notion of quantitative easing (QE). Sometimes incorrectly referred to as ‘printing money’ (listen to Dave McLeish’s comments on that topic here) it involves the central banks, like New Zealand’s Reserve Bank, buying bonds on the open market in return for liquid deposits, money.
QE is an important tool in the central banker’s armoury, helping achieve two key outcomes. First it provides liquidity for the banking system enabling longer term bonds to be swapped for cash and for that cash to potentially be on lent by the banking system. QE also tends to drive longer maturity interest rates lower which, all things being equal, which should stimulate investment and support economic growth.
Since the coronacrisis central banks around the world have bought US$10 trillion of assets. QE is also an important adjunct to government borrowing programs. In the US, for instance, the Federal Reserve Bank will buy about $2.5 trillion of the total bond issuance of $4 trillion this year. The arithmetic is not dissimilar in New Zealand.
This will not be inflationary, at least for now. Inflation occurs when there is too much money spent chasing too few goods - ‘demand pull inflation’ for the economics students out there - or when there are supply side influences pushing up costs, like higher wages.
With the global economy in a significant slump there is a shortage of demand. Consumers are incredibly cautious and cost pressures are almost non-existent, as is business pricing power. This is not an environment for inflation. Deflation, or falling prices is a far more significant risk, at least in the short term.
This can change, and warrants careful monitoring, but will likely be a protracted process. It may take a long time for demand to ramp back up, for unemployment to fall back to pre-crisis levels and for cost pressures to emerge again.
Inflation is a risk we take seriously but it’s a risk not even close to flashing amber.
Will we end up with negative interest rates?
A risk that is much more front and centre is the possibility of negative interest rates.
There are sound reasons why negative interest rates might make sense for many economies including New Zealand’s.
The “right” interest rate for an economy is a much debated topic but is broadly a function of economic growth, productivity changes and expected inflation. If economic and productivity growth is weak and inflation negligible, then the optimal interest rate, one that balances the economy wide desire to save with the desire to borrow, will tend to be low.
It is possible, and in some parts of the world highly likely, that the right neutral interest rate that balances these economic forces, across a cycle, is close to zero.
This creates a problem. In recessions having an interest rate lower that the typical neutral level is an important tool to stimulate the economy. If the neutral level is already close to zero a negative rate may be necessary to stimulate the economy.
In fact it’s even worse than that. If the “fair” neutral interest rate has dropped below zero in a weak economic environment, if rates don’t head to negative territory even a small positive rate might act as a hand brake on growth. That is the last thing New Zealand or the global economy needs right now.
Negative interest rates are a real possibility for New Zealand and an important tool that the Reserve Bank has at its disposal to stimulate our economy.
Like many tools it’s not without its issues. Negative rates pressure the profitability of the banking and insurance sectors and can create financial system instability. That is clearly a bad thing.
There is also the worry that retail investors might end up having to pay to keep money in the bank, which is pretty unpalatable. Thankfully this is unlikely, except for those with very large balances, based on the international evidence from those countries that have had negative central bank interest rates for some time.
Do negative rates mean negative mortgage rates (will the bank pay you to have a mortgage!)?
Sorry, it is very unlikely that the Bank will pay you for your mortgage!
While central bank interest rates might be negative, the trading banks make money by charging a spread, or extra interest rate, over this. With the exception of some mortgages from Danish Jsyke Bank, negative rate mortgages aren’t a feature even for those countries that have had negative rates for some time. Even Jyske Bank gets its pound of flesh through fees, so it is not as good as it seems.
Expect to still pay interest on your mortgage, albeit if the RBNZ drops rates below zero, it is likely to be lower than ever before.
Surely all this money being created out of thin air can’t end well?
We are living through an unprecedented monetary and fiscal policy experiment. Policy makers are firing a fiscal and monetary bazooka in response to a sharp global recession.
Unfortunately the bazooka is being fired into the mist. While the actions of governments and central banks will support the economy in the short term, given the multi layered complexity of the economic machine, the potential long term impacts of this are less well understood.
History has shown, though, that once the monetary and fiscal spigots have been opened it is very hard to turn them off. In part, because it is tempting for governments to keep the spend going – it’s much easier delivering good news than bad news. But also because financial markets, as we have seen since the global financial crisis, have tended to be fragile as policy support is removed.
Governments have become important participants in financial markets. Policy risk is more of a consideration today than at any time in my investing career.
While understanding exactly how this plays out is hard, in my view it underscores the importance of real assets in portfolios.
Continued low interest rates (but with some risks to upside), more adventurous fiscal policy and potential currency debasement all lurk on the far horizon. Owning high quality businesses making things people need, quality property and having an interest in the infrastructure that runs the global economy all feel like important stores of value that can perform even if some of the shots from the bazooka miss the target.