The U.S. Federal Reserve has left little doubt that it intends to chop its key lending rate, probably by a quarter of a percentage point, when it wraps up a two-day meeting Wednesday.Win McNamee/Getty Images
The sloshing sound you hear is that of easy money seeping back into the global economy.
Around the world, a growing number of central banks are cutting, or preparing to cut, interest rates – something policy-makers usually do when economies are in distress. Yet the monetary-powers-that-be are delivering their rate cuts to a global economy that appears to have slowed only marginally.
In the United States, the case for a rate cut is particularly questionable. Stock markets are hovering around record highs, while unemployment has sunk to half-century lows.
Nonetheless, the U.S. Federal Reserve has left little doubt that it intends to chop its key lending rate, probably by a quarter of a percentage point, when it wraps up a two-day meeting Wednesday. If so, it will be the Fed’s first rate cut since the financial crisis a decade ago.
What is prodding the world’s most powerful central bank to goose an economy that is growing at a healthy 2.1-per-cent clip? It may be about buffering businesses against the fallout from trade tensions and other uncertainties. But, more fundamentally, it is a demonstration of how investors and households have become addicted to low interest rates after years of rock-bottom borrowing costs.
The mere whiff of higher rates last year was enough to send stock markets tumbling. Now, central banks appear to be counting on a new round of rate cuts to address everything from trade issues to slowing U.S. growth.
The Bank for International Settlements, an international organization of central banks, is among those raising the alarm about the global economy’s unhealthy dependence on low rates as an all-purpose cure-all for economic problems.
“The continuation of easy monetary conditions can support the economy, but makes normalization more difficult through the impact on debt and the financial system,” it warned in its annual report last month.
Among the warning signs the BIS points to are the proliferation of lower-quality corporate debt, the run-up in household borrowing in countries such as Canada and the growing number of “zombie” firms that are unable to cover their debt-servicing costs from current profits, usually because they have borrowed heavily in a low-rate environment.
No one doubts that low rates helped the global economy recover from the financial crisis by driving up asset prices and encouraging borrowing. What is less clear, however, is whether a new round of rate cuts can do much to address the structural problems now facing the U.S. and other developed economies. At the very least, the Fed’s flip-flops on rate policy in recent months run the risk of leaving the market thoroughly confused about what is coming next.
“I think the Fed may be undermining its own credibility,” says Megan Greene, a senior fellow at the Harvard Kennedy School and a former chief economist at Manulife Asset Management. “My worry is that the Fed is going to cut and it’s not going to do much to boost inflation or growth. That would leave it less prepared to face the next downturn.”
The Fed is usually regarded as a deft steward of the U.S. economy. But that doesn’t mean it can’t occasionally stumble. One of the most remarkable aspects of its expected cut next week is that it amounts to a complete about-face from what the central bank was trying to accomplish just last autumn.
Back then, the Fed was intent on raising rates, not lowering them. It wanted to push borrowing costs back to more historically normal levels, a sign the world was finally emerging from the long shadow of the financial crisis. In December, Fed Chair Jerome Powell boasted that key parts of the central bank’s monetary-tightening program were on “autopilot.”
Instead, Mr. Powell and the Fed discovered that low rates are far stickier than anyone thought. Share prices provided the most immediate sign of the damage higher rates could cause. As the Fed raised rates last year and pointed at more hikes to come, stock markets plummeted in the final quarter of the year. The bank abruptly changed its tune when confronted with the reality of cratering portfolios.
Share prices weren’t the only force pushing back against rate hikes. U.S. President Donald Trump started hectoring Mr. Powell on the need for lower rates. Meanwhile, worries were growing over the ripple effect of Mr. Trump’s trade war with China, as well as the fading impact of the administration’s big tax cuts.
Both those latter factors continue to hang over the global economy. So has the growing possibility of a no-deal Brexit and evidence that the euro-zone economy is slowing. In response, policy-makers in Australia, New Zealand, India, Indonesia, South Africa, Malaysia, the Philippines and South Korea have all trimmed interest rates since April.
Even central banks that already maintain key rates below zero are doing their best to stress their dovish intentions. Last month, the Bank of Japan reiterated its intention to keep short-term interest rates below zero and borrowing rates on 10-year government bonds around zero. This week, the European Central Bank added its voice to the easy money chorus, signalling it intends to cut rates in September, pushing them even further into negative territory.
To date, the Bank of Canada has steadfastly remained outside this global rate-cutting party. It has instead maintained a key policy rate of 1.75 per cent. But some observers expect it to join the worldwide trend sooner rather than later.
“The Bank of Canada is closer to cutting than the consensus thinks,” insists Stephen Brown, the senior Canada economist at Capital Economics. He expects the bank’s key rate to fall to 1 per cent next year as the Fed cuts deepen and the construction sector slows.
But is the outlook really so dim? Despite his outlook for Canadian interest rates, Mr. Brown is quick to stress that readings on the real economy are not yet registering any widespread pain. The oil patch has encountered its problems over the past year, but other areas have been holding up well.
The picture is similarly mixed in the U.S. For every negative indicator – an inverted yield curve, slowing rail traffic, lacklustre levels of home construction – there are offsetting positives: a remarkably robust jobs market, strong corporate earnings and healthy consumer spending.
All of this makes it difficult to understand why the Fed has been so clearly signalling its intention to cut rates next week. In speeches and presentations, senior officials have dropped a steady stream of hints suggesting a rate cut is on the way.
Conventional thinking would suggest that Mr. Powell and his colleagues should wait for more definite signs of weakening before trimming the key federal funds rate – the benchmark rate for overnight loans among U.S. banks – from its current target band of 2.25 to 2.5 per cent. By historical standards, the current rate already constitutes easy money.
One theory is that the Fed is simply acknowledging that it is out of step with the rest of the world. Compared with the euro zone (where the key interest rate is minus 0.4 per cent) or Britain (0.75 per cent) or Australia (1 per cent), U.S. rates look distinctly lush.
An even more popular theory is that the Fed wants to take out insurance against any possible slowdown related to the U.S.-China trade war and the fading effect of U.S. fiscal stimulus.
Eric Lascelles, chief economist at RBC Global Asset Management, argues the Fed is simply playing the odds. It probably still expects decent growth as the most likely scenario. However, it may see a roughly 30-per-cent chance of a significant downturn. If so, there is a reasonable case for policy-makers to administer a minor rate cut now, to give them a head start on the much deeper cuts that might be needed if a downturn materializes.
Ms. Greene differs. She thinks the Fed’s greatest worry is fading expectations for inflation. Market gauges show investors no longer expect long-run inflation to hit the Fed’s 2-per-cent target.
There is a risk that people could begin to expect disinflation or even deflation – a scenario in which much central bank policy would become ineffective. If so, a dose of low-rate therapy may help boost inflationary expectations.
But that’s a big if, because the traditional policy prescriptions are no longer as dependable as they once were. Central banks typically attempt to manage economic growth and inflationary expectations by adjusting short-term interest rates up or down. Lower rates are supposed to encourage home construction and business activity by making it more attractive to borrow money.
The problem with that view right now, Ms. Greene notes, is that the U.S. and other developed countries have already experienced a decade of exceptionally low interest rates. It is difficult to believe that lowering rates by a further fraction of a percentage point will have much of an impact. “In the U.S., you can say pretty definitively that borrowing costs are not really a problem,” she says.
She argues that lower rates cannot address the structural problems that afflict the economy – issues such as the trade conflict between the U.S. and China and the long-run disinflationary impact of globalization and technology.
The Fed could be creating problems for itself if it cuts rates too enthusiastically in the coming months. Typically, it cuts its key federal funds rate by about five percentage points during a recession. But with the federal-funds level now at just 2.5 per cent, it has only half as much room to move. If it uses that space now, it will have even less room to manoeuvre when a downturn does hit.
“My concern is that if the Fed cuts now, it may not accomplish much and it could lose credibility,” Ms. Greene says. “Whenever the next recession starts, it would be starting from a weaker position.”
Ultimately, how low central banks take interest rates will hinge on what rate is necessary to both encourage full employment and hit inflation targets. One view gaining traction holds that aging populations, slow-growing work forces and lacklustre productivity gains are going to put a lid on interest rates in developed countries for a long, long time.
John Williams, president of the Federal Reserve Bank of New York, argued in a speech this month that there has been a big fall since 2000 in long-run neutral rates – the after-inflation interest rates that would be appropriate in an advanced economy running flat out. In the U.S., Canada and other developed countries, the long-run neutral rate is now a mere 0.5 per cent, he estimated.
“These very low neutral rates are a result of long-term structural factors slowing growth,” he said. “They’re driven by demographic changes and slow productivity growth, which are unlikely to reverse any time soon.”
The danger, though, is that low borrowing costs can breed financial instability. Over the past decade, both individuals and companies have gone on a borrowing binge. That makes it almost impossible for central banks to raise rates significantly without imposing pain on heavily indebted consumers and businesses.
“The longer that people go in an environment of lower rates, the more accustomed they get to them – and the more difficult it is to raise borrowing costs,” observes Mr. Lascelles at RBC.
In Canada, for instance, household debt levels have soared in recent years as interest rates have fallen. Household debt has also reached record peaks in several other countries, according to the BIS. Meanwhile, the ratio of debt to earnings among publicly listed firms in the U.S. has hit its highest level on record.
Canadian household debt vs. interest rates
Bank of Canada’s key lending rate (left axis)
Household debt to GDP (right axis)
4.5%
105%
4.0
100
3.5
95
3.0
90
2.5
85
2.0
80
1.5
75
1.0
70
0.5
65
0.0
60
2005
’09
’13
’17
Note: BoC rates at quarterly end
THE GLOBE AND MAIL, SOURCE: ST. LOUIS FED
Canadian household debt vs. interest rates
Bank of Canada’s key lending rate (left axis)
Household debt to GDP (right axis)
4.5%
105%
4.0
100
3.5
95
3.0
90
2.5
85
2.0
80
1.5
75
1.0
70
0.5
65
0.0
60
2005
’07
’09
’11
’13
’15
’17
Note: BoC rates at quarterly end
THE GLOBE AND MAIL, SOURCE: ST. LOUIS FED
Canadian household debt vs. interest rates
Bank of Canada’s key lending rate (left axis)
Household debt to GDP (right axis)
4.5%
105%
4.0
100
3.5
95
3.0
90
2.5
85
2.0
80
1.5
75
1.0
70
0.5
65
0.0
60
2005
2007
2009
2011
2013
2015
2017
Note: BoC rates at quarterly end
THE GLOBE AND MAIL, SOURCE: ST. LOUIS FED
Yet there is no sign that the appetite for debt is slowing down. In fact, many investors appear to be dispensing with caution as they hunt for yield in a low-rate world.
The share of corporate-debt issuers with the lowest investment-grade rating has soared in both Europe and the U.S. since 2000, according to the BIS. These bonds are vulnerable to any economic hiccup that could jeopardize companies’ ability to service their debts. “A further drop in ratings during an economic slowdown could lead investors to shed large amounts of bonds quickly,” the BIS notes in its latest annual report.
If such a sell-off does happen, investors should not expect much of a cushion. An indicator compiled by Moody’s Investors Service shows that the quality of covenants on North American debt – a measure of the degree of investor protection on those loans – hit its lowest level on record earlier this year. “Loan covenant protections remain starkly weak by historical standards,” Moody’s most recent report says.
Covenant Quality Indicator
Covenant quality, a measure of the degree of
legal protection that bond lenders are demanding,
has hit record lows in recent months as investors
reach for yield.
CQI
Weakest-level protection threshold
3.2
3.4
Stronger
3.6
3.8
4.0
Weaker
4.2
4.4
4.6
2012
2014
2016
2018
THE GLOBE AND MAIL, SOURCE: MOODY’S INVESTOR SERVICE
Covenant Quality Indicator
Covenant quality, a measure of the degree of legal
protection that bond lenders are demanding, has hit record
lows in recent months as investors reach for yield.
CQI
Weakest-level protection threshold
3.2
3.4
Stronger
3.6
3.8
4.0
Weaker
4.2
4.4
4.6
2012
2014
2016
2018
THE GLOBE AND MAIL, SOURCE: MOODY’S INVESTOR SERVICE
Covenant Quality Indicator
Covenant quality, a measure of the degree of legal protection that bond lenders are demanding,
has hit record lows in recent months as investors reach for yield.
CQI
Weakest-level protection threshold
3.2
3.4
Stronger
3.6
3.8
4.0
Weaker
4.2
4.4
4.6
2011
2012
2013
2014
2015
2016
2017
2018
’19
THE GLOBE AND MAIL, SOURCE: MOODY’S INVESTOR SERVICE
The large amounts of lower-quality debt now in the system are at the heart of the problem facing central banks such as the Federal Reserve. After last year’s debacle, it is understandably wary of raising interest rates any time soon. But if it lowers rates too much, it risks encouraging even more borrowing, especially of the risky variety.
That sets up tough decisions ahead, especially if the economy does begin to sputter.
The one thing that seems certain? Easy money will be with us for a long time to come.
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Ian McGugan