Rate Policy Has Become Self-Defeating

Economies are slowing and central banks are pumping out more liquidity. The European Central Bank cut overnight rates to negative 0.5% on top of an agreement to purchase 20€ billion bonds per month.  The Federal Reserve is expected to provide additional easing in the coming days. At last count, nearly $17 trillion of bond outstanding globally sport a negative yield.

We worry that not only will central banks’ easy rates not achieve their desired effect, but also that many of the challenges policymakers are currently facing–including low inflation and disappointing productivity–are the direct result of those same policies.

Companies borrowing money and enjoying expanded profits through financial leverage are ramping up debt levels like never before. Non-financial corporate debt outstanding accounts for 30 per cent of GDP, nearing its highest level in recorded history. Washington is at the bond trough, too: for the first time since August 2012, the fiscal 2019 US budget deficit, financed by cheap Treasury borrowings, breached the $1 trillion mark and now represents about 4.4 per cent of GDP.

Thanks to generous financing rates and the availability of credit, zombie companies–corporate entities that should be out of business–remain going concerns. Sears is a good example. Even though the company filed for Chapter 11 bankruptcy in October 2018, Sears Holdings continues to operate 425 stores and has 45,000 employees. Because Sears, and companies like it, continue operating competition remains higher and prices lower than they otherwise would be. Zombie companies keep real estate values elevated by occupying spaces that they otherwise would not be.

Operating a business used to be difficult, but thanks to below-market interest rates the bar has been lowered significantly. Creative destruction is dead in many industries, attenuating the competitive forces that drive productivity gains. Productivity, the silver bullet that fuels economic growth without inflation, has steadily declined in recent years and this trend has only accelerated with below-market interest rates. Ten-year trailing productivity growth is at its lowest level since 1987, due in large part to the nanny state for businesses that the world’s monetary authorities have created.

Now, the Federal Reserve and the other central banks find themselves in a bind, no longer able to normalize rates. When Chairman Jay Powell attempted to restock his Fed’s ammunition last year at this time, the markets convulsed. Powell adroitly reversed course and risk-taking resumed.

Holding interest rates below fair value has created a bubble in corporate credit, akin to what happened when homeowners had unencumbered access to easy mortgages and bought houses many could not afford. While the Fed is aware of the situation, the question is: how can they back away from their current policy without credit market tears?

 

Rate Policy