Low interest rate environment

Posted By Darren Winters on Dec 4, 2019

Low interest rate environment

The public and private sector can borrow lower than the historic average in a low-interest-rate environment. So in troubling economic times, the central bank implements a monetary easing policy that fosters a low-interest-rate environment. In theory, a low interest rate environment stimulates investing and spending, thereby boosting economic activity.

That’s a school textbook theory of monetary easing in a nutshell. 

But a case study of Japan could give us a glimpse into the reality of a low-interest-rate environment

The Bank of Japan (BoJ) has implemented a negative interest rate policy (NIRP) for more than a decade with mixed results. Consumption remains lacklustre with economic growth being elusive.

The BoJ’s NIRP policy has seen economic stagnation with economists dubbing it Japan’s lost decade. 

So is the European Central Bank (ECB) and Federal Reserve (Fed)  following the BoJ footsteps into the low interest rate environment abyss?

Low interest rate environment

ECB President, Christine Lagarde famously said, “we should be happier to have a job than to have savings” in support of a low interest rate environment. The ECB’s deposit rates are -0.5%(negative) and will extend its multi-billion-euro monthly asset purchases, also known as quantitative easing QE.

But any high school student of economics knows that it is business investments that create employment. Moreover, it is savings, in a sound financial system, which then provides banks with a supply of investment funds. So if you attack savers with NIRP, you cut-off the organic supply of investment and jobs.

It appears that ECB President, Christine Lagarde doesn’t seem to grasp basic economics, believing that penalizing savers and creating euros through keyboard stokes is the way to create jobs and stimulate the economy. 

Increasing the money supply indefinitely without any increase in productivity and the economy debases fiat currency to junk. Venezuela and Nigeria are two countries currently experiencing a currency crisis due to monetary policy stupidity.

So is ECB President, Christine Lagarde steering the EU into the low interest rate environment abyss? 

German bankers are now publicly growing wary over the low interest rate environment?

The “risks to financial stability have continued to build up in Germany,” the Bundesbank warns in its Financial Stability Report 2019.

Bundesbank, Germany’s central bank is concerned that Germany’s current economic slowdown could turn into an “unexpected economic downturn”. 

Germany’s export-led economy has stagnated over the last five quarters as global trade has slowed. 

Bundesbank is concerned about “deterioration in the debt sustainability of enterprises and households” which in turn could lead to cascading loan defaults and credit write-downs. 

A low interest rate environment has pushed banks into “relatively high-risk businesses” according to the report. “There are signs that banks’ lending portfolios now include a higher share of enterprises whose credit ratings could deteriorate the most in the event of an economic downturn,” wrote the Bundesbank report. 

Germany’s central bank is also concerned about the real-estate bubble

Bundesbank estimates that property prices in German towns and cities are overvalued by between 15% and 30%. That might not be an exaggeration, bearing in mind that the 2019 Global Real Estate Bubble Index cites Munich real estate as now the most overpriced in the world. In 2018 residential real estate in Germany grew at an average rate of 8%. If the real estate bubble bursts and the economic slowdown turns into a deep recession it could trigger large real estate loan defaults in the German real estate market. But don’t panic, because both households and lenders expect prices to continue rising long into the future, according to the survey. 

Credit agency Moody’s has downgraded its outlook for German lenders from “stable” to “negative” as profitability and creditworthiness deteriorate in a low interest rate environment

“Banks’ weak profitability will decline further as net interest income falls,” the report said. German banks have been hit with low levels of profitability. As of 2018, banks in the country had an average return on equity (ROE) of just 2.4%, the second-lowest level in the EU after Greece and sharply lower than the EU average (6.1%). 

Meanwhile, the Fed has also been following major central banks’ footsteps into a low-interest-rate environment with its rate cut trio to a range of 1.5% to 1.75%. The Fed also abandoned quantitative tightening and returned to expanding its balance sheet by approximately $60B a month to dampen the fire in the Repo market, which is a clear sign that there is trouble in the engine room. The Fed’s balance sheet has now accumulated to $4.2T of assets and that is blowing air into the multiple asset bubbles. 

But it is worth noting also that the FOMC Committee is not unanimously in cahoots with a low-interest-rate environment. 

Fed President John Williams warned a few years ago that low neutral interest rates are a  sign of possible changes in the US economy that the central bank does not fully understand. 

“I see this as more of a warning, a red flag that there’s something going on here that isn’t in the models, that we maybe don’t understand as well as we think, and we should dig down deep deeper and try to figure this out better” he said during a panel discussion at the Brookings Institute in Washington. 

Fed chair Jay Powell’s recent message to Congress is that the Fed has put a floor under a low-interest-rate environment. 

There’s no room to cut warned Fed Chair Powell to Congress in November

So the common view that the Fed will not be able to cut interest rates enough to significantly mitigate (let alone turn around) a major recession is true. 

Fed chair Jay Powell noted that during a downturn the Fed has historically cut interest rates by about five percentage points. Currently, interest rates are at 1.75%. 

But surely the Fed could follow the ECB and the BoJ into NIRP. That’s not so easy when you hold the heavyweight title as the world’s reserve currency. So the Fed has ruled out NIRP, which implies that the Fed has only about a third as much room, as usual, to cut rates in response to a recession.

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