Why the global economy can’t handle higher interest rates

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Canada marks a significant anniversary this year, even if it’s not one that is going to be celebrated with cakes and fireworks.

It was 10 years ago, in April, 2009, that Bank of Canada governor Mark Carney chopped interest rates for the final time, taking them as low as they could go, within a hair of zero. He framed his decision as an emergency act, a temporary measure designed to meet the needs of an economy caught up in a global financial crisis. Unemployment was rising quickly, on its way to nearly 9 per cent.

What is remarkable is how little interest rates have budged since then. In the intervening years, the Canadian economy has bounced back from its crisis-era layoffs, with the unemployment rate now at 5.8 per cent, near a half-century low. However, the central bank’s key interest rate has only inched up slightly – to all of 1.75 per cent, a rate that before the crisis would have seemed remarkably low.

This was not the way things were supposed to work. Policy-makers expected a far quicker, far more vigorous rebound in interest rates that would take us back to normal in short order. But Canada and the rest of the globe are discovering an inconvenient truth: Once you enter the world of low interest rates, it is awfully difficult to leave.

Is this a good thing? For home buyers, yes. They have benefited for years from unusually low borrowing costs on their mortgages. Stocks, too, have received a boost as microscopic yields on bonds and savings accounts have driven many savers into the equity markets.

However, for anybody who would like to see their savings increase in a bank account, or for those concerned about the economy as a whole, the past decade raises some disturbing questions about the unintended side effects of easy money.

Consider, for instance, the way that debt has soared in response to lower borrowing costs. Canadians have continued their borrowing binge in recent years, sending household and corporate debt to record levels as a percentage of the overall economy. Residents of other countries have also gone deeply into hock. So, too, have companies and governments across both the developed and emerging markets.

Bank of Canada senior deputy governor Carolyn Wilkins noted this month that global debt is now US$100-trillion higher than just before the financial crisis. (Yes, that is trillion with a “t.") You don’t have to be a central banker to worry about the financial fragility that goes along with that unprecedented level of financial leverage.

“Whether you are a homeowner or a businessperson, you know first-hand that high leverage can leave you in a vulnerable financial position,” Ms. Wilkins said. “It’s no different for economies.”

It’s not just the amount of debt that has people worried; it’s also what happens when the global economy hits its next downturn, as it inevitably will.

Central banks typically slash interest rates by four to five percentage points in recessions to help restart the economy. But if rates stay as low as they are now, monetary policy-makers won’t be able to offer much help. Any attempt to severely lower rates would quickly run them down to zero, at which point it would become difficult to lower rates much further.

Canada is just one of many countries facing this constraint. “Should a recession arrive, the U.S. Federal Reserve would ideally be able to cut interest rates by five percentage points, as is customary in such situations,” Brad DeLong, an economist at the University of California at Berkeley, wrote this month.

“But with short-term safe interest rates currently at 2.4 per cent, it cannot. And with euro and yen interest rates still around zero, the European Central Bank and the Bank of Japan would be unable to help much either.”

Why haven’t central banks raised rates more aggressively in good times, to give themselves more room to cut in a downturn? The answer is they have tried, but without success.

Japan is the purest example of the problem. This year marks the 20th anniversary of its zero-rate policy. Over the past two decades, it has attempted to raise rates on several occasions, but always runs into resistance from a faltering economy.

North American central banks are now bumping up against the same resistance. This past fall, Bank of Canada Governor Stephen Poloz and Federal Reserve chair Jerome Powell were both signalling higher rates ahead. They seemed, at long last, to be making a clean break from the unusually low rates that had prevailed since the financial crisis.

Then, as stock markets swooned late in the year and evidence grew of a global slowdown, both central bankers had to perform an about-face. They reeled back their talk of rate hikes and pledged to be patient and wait for new data before making any further move.

Maybe their retreat was just a temporary halt, the result of concerns over Brexit and China-U.S. trade tensions. However, it is legitimate to wonder whether the economy is now hooked on low rates, to the point where withdrawing from them would be too painful to contemplate. Raising rates too far might mean falling home prices, crumbling stock prices, a slowing or contracting economy.

The build-up of all that debt may have made the economy exquisitely sensitive to any attempt to raise rates. If so, the current era of low rates could last a long, long time.

The bond market certainly thinks so. The yield on the 10-year Government of Canada bond has tumbled in recent months and hit its lowest point since mid-2017 this past week at 1.53 per cent – just a hair above the yield on two-year bonds.

That suggests investors think we are unlikely to see any substantial rise in interest rates, and therefore bond yields, for the foreseeable future. If bond buyers figured rates were set to climb sharply in coming years, they would be demanding much more of a premium to tie up their money for a decade.

Other market indicators agree that rates aren’t going up any time soon. In the United States, the yield on three-month government bonds moved higher than the 10-year yield earlier this month, signalling that more rate cuts may be on the way. The futures markets are betting that both the Bank of Canada and the Federal Reserve will cut rates at least once this year. (On Friday, White House economic adviser Larry Kudlow told news outlet Axios that he wanted to see the Fed cut rates immediately by half a percentage point.)

The idea that rates could resume their downward course after years of already low rates does not jibe easily with textbook explanations of how the economy works. By now, many observers are beginning to wonder how well we understand the levers of the financial system.

“Stunning” is how Justin Wolfers, an economist at the University of Michigan, described the most recent set of Federal Reserve forecasts. It “would have seemed almost unthinkable a decade ago,” he noted, for a central bank to predict exceptionally low unemployment, but with no inflationary pressure and with interest rates below 3 per cent.

One of the biggest question marks in the current debate is the Phillips Curve, a time-honoured notion that insists there is a trade-off between unemployment and inflation.

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The Phillips Curve provides the standard explanation for why central banks do what they do: By lowering rates in times of slow economic growth, policy-makers supposedly boost borrowing and goose business activity. This leads to more jobs and a more vibrant economy, which then spurs higher inflation and ultimately a return to more normal interest rates.

All this sounds great on paper. However, the Phillips Curve has been missing in action since the financial crisis. Yes, rates have gone down and unemployment has dived in both Canada and the United States. However, inflation has only flickered modestly upward and economic growth has remained mostly mediocre. As a result, there has been little pressure to bump up interest rates.

Could it be that we don’t know as much as we thought we did about how modern economies work? Stephen Williamson, a professor of central banking at the University of Western Ontario, notes that it has always been difficult to see any type of stable, reliable Phillips Curve in real world data. Yes, countries with higher nominal interest rates tend to have higher inflation, but it’s not clear which causes which.

“People at central banks find [the Phillips Curve] a useful way to explain what they’re doing, even if it’s not actually theoretically or empirically useful,” Prof. Williamson said in an interview.

His comments point to the lack of consensus about the best path forward. While Prof. Williamson dismisses the Phillips Curve, other experts, such as Harvard professor Kenneth Rogoff, are willing to double down on the power of lower interest rates. He argues that much lower rates – negative rates, in fact – are going to be required if the economy takes a serious stumble.

This is not just a theoretical debate. The stockpile of global bonds with below-zero yields has hit US$10-trillion, according to Bloomberg data. In at least 18 countries, mostly in Europe, investors receive negative yields on at least some government bonds, meaning that buyers of these securities are paying for the privilege of saving.

It’s entirely possible that negative rates could come to North America as well if a severe recession were to hit. But whether that would be a good idea hinges on what is ultimately driving the trend toward lower rates.

One of the more intriguing views comes from Larry Summers, the Harvard economist and former U.S. Treasury secretary. He presented a paper earlier this month, written with Bank of England economist Lukasz Rachel, in which he developed his argument that the developed world is suffering from secular stagnation, a long-term slowdown in economic growth.

In Mr. Summers’ view, demographics are one of the major reasons for this slowdown. People are living longer, enjoying extended retirements and having fewer children. As labour force growth slows, so does growth in consumer demand. Yet, longer lifespans and longer retirements mean people are trying to save more than ever.

The result? A glut of savings is overwhelming the ability of the private sector to put those savings to productive use. In other words, there’s a lot of capital available – but not enough demand from businesses to invest it all. Since the supply of money is ample but the demand for it is weak, the cost of borrowing money goes down.

This process has been going on for a generation, but has become particularly noticeable over the past decade. As things now stand, we have entered an era of “extremely low interest rates, weak demand, and low growth and inflation,” Mr. Summers writes. Just like Japan.

His preferred prescription is for governments to spend more aggressively, running up deficits that can usefully absorb some of that pile of savings. In addition, he suggests looking for ways to reduce the need for people to save – perhaps by offering them more in the way of government-paid retirement benefits.

As you might imagine, his proposals aren’t universally loved, especially by people who object to the potential explosion in government debt. But the mere fact that such ideas are being discussed a decade after we hit an interest-rate bottom underlines how unusual this economic environment has been. Canada and the world still have a long way to go to reach anything that looks like normalcy.