Central banks are rushing to provide additional support as the economic outlook darkens. However, there are growing fears that policy loosening might be doing more harm than good at present, warns Aberdeen Standard Investments in its recent “Macroscope”.
This so-called ‘reversal rate’ at which rate cuts become counterproductive is seen as working through a number of channels, including weak bank profitability; credit misallocation; softer household and corporate confidence; and low returns on saving. “But although there are some justifiable concerns over the unintended consequences of lower rates, we need to take into account the whole picture”, says the asset manager.
Indeed, most empirical evidence does not suggest that the costs of lower interest rates are outweighing their benefits, suggesting that policymakers have not reached a reversal rate (yet). This debate is a symptom of how much pressure is being put on monetary policy.
Then, how low can you go?
Historically, there have been concerns that a move into negative rates would prompt deposit flight from banks. However, says ASI, there have been few signs of an explosion in cash under mattresses. Instead, the fear has shifted to bank profitability: “banks have been unwilling (or legally unable) to fully pass on negative interest rates to depositors, providing a squeeze on net interest margins and profits”.
The fear is that this could undermine capital positions in the sector, leading to a reduced capacity to lend and driving a tightening in credit conditions. Besides, according to the asset manager, rate cuts beyond certain levels could sap confidence, as households and businesses see these as a sign of economic malaise.
“In economies with high domestic savings rates the lower return on these could encourage even more cautious activity”. Finally, the BIS has been keen to highlight the risks of credit misallocation as interest rates fall ever lower.
Ever-lower interest rates may well generate unintended negative consequences, but ASI points out that there are mitigating forces at play that need to be taken into account. For example, the squeeze on bank margins might be offset by higher lending, not to mention a boost from asset holdings.
Indeed, while the overall evidence is mixed, most credible studies do not support the conclusion that interest rates have fallen to a level at which the unintended consequences outweigh the benefits. “However, the fact that these exist adds to the case for fiscal policy to take more of the strain. Sadly, it does not feel as if governments are stepping up to the plate”, says ASI.
Another problem for banks
On the banks’ front, the fear is that lower interest rates could weigh on net interest margins and in extremis push deposits out of the sector. This might limit banks’ ability to pass through lower interest rates to the real economy and in some cases even force them to contract their balance sheets, lowering credit availability.
What banks need most in order to maximise the effectiveness of lower policy rates is 1) demand for credit, 2) an ability to lend at high leverage ratios and 3) for that the lending to be done at higher net interest margins – where curve steepness helps a great deal.
According to ASI, our starting point is that many banking systems, particularly those in Europe, are already struggling for profitability a decade on from the financial crisis and not just because of crimped margins. Post-crisis regulatory capital requirements more than quadrupled in some cases and banks needed to raise and retain substantial levels of new capital in order to comply.
Lending is now done at much lower multiples that require higher margins to maintain profitability. “However, weak growth, economic uncertainty, ageing populations and already high levels of debt have been drivers of lower demand for credit through the cycle”.
Reduced profitability since the crisis has affected banks worlwide. However, the problems have been most acute outside the US. The asset manager thinks that bond yields are a useful measure of market expectations for long-term growth and inflation, so it is no surprise that as European bond yields moved deeply negative, bank stocks continued to underperform other equities. “The cocktail of low growth, inflation and rates is clearly an unpalatable one for this sector”.
