We Can Have Low Interest Rates Or Robust Growth. But Not Both.
Central banks should know by now that you cannot have negative interest rates with low bond yields and strong growth. One or the other.
Central banks have chosen low bond yields at any cost, despite all the evidence of stagnation ahead. This creates enormous problems and perverse incentives.
It is not a surprise that markets have bounced aggressively, driven by the tech sector, after a slump based on concerns about the pace of economic growth. Stimulus package effects are increasingly short, and this was pretty evident in the poor figures of industrial production and the ZEW survey gauge of expectations. The same can be said about a weakening ISM index in the United States. United States ISM Services PMI came in at 60.1, below expectations (63.5) in June, precisely in the sector where the recovery should be strongest.
Interestingly, European markets declined sharply after the European Central Bank sent the ultimate dovish message, a change in its inflation target that would allow the central bank to exceed its 2 percent limit without change of policy. What does it all tell us?
First, that the placebo effect of stimulus packages shows a shorter impact. Trillions of dollars spent create a small positive effect that lasts for less than three months but leaves a massive trail of debt behind.
Second, central banks are increasingly hostage to governments that simply will not curb deficit spending and will not implement structural reforms. The independence of the monetary authorities has long been questioned, but now it has become clear that governments are using loose policies as a tool to abandon structural reforms, not to buy time. No developed economy can tolerate a slight increase in government bond yields, and with sticky inflation in nonreplicable goods and services, this means stagnation with higher prices ahead, a bad omen for the overall economy.
Third, and more concerning, market participants know this and take incremental levels of risk knowing that central banks will not taper, which leads to a more fragile environment and extreme levels of complacency.
So-called value sectors have retraced in equity markets, which shows that the recovery has been priced and that the risk ahead is weakening margins and poor growth, while the traditional beneficiaries of “low rates forever” have soared to new highs.
Despite rating agencies’ concerns about the rising figure of fallen angel debt, there is extreme complacency among investors looking for yield, and they are buying junk bonds at the fastest pace in years despite a rising number of bankruptcies.
Central banks justify these actions based on the view that inflation is transitory but ignore the risks of elevated prices even if the pace of increase in those prices slows down. If food and energy prices rise 30 percent, then fall 5 percent, that is not “transitory” to consumers who are suffering the above-headline increase in the prices of the things they purchase every day, a problem that occurred already in 2020 and 2019. The most negatively affected are the middle-low and poor classes, as they do not see a wealth effect from the rise in asset prices.
Sticky inflation and misguided loose fiscal and monetary policies are not tools for growth, but for stagnation and debt.
So far, central banks believe their policies are working, because equity and bond markets remain strong. That is like giving more vodka to an alcoholic because he has not died of cirrhosis yet. Low bond yields and high levels of negative-yielding debt are not signaling monetary success but are evidence of a deep disconnection between markets and the real economy.
Central banks have already stated that they will continue with ultraloose policies no matter what happens to inflation in at least a year and a half. For consumers that is a lot of time for weakening purchasing power of salaries and savings. Markets may continue to reward excess and high risk, but that is not something that should be ignored, let alone celebrated. Extreme risk will be blamed for the next crisis, as always, but the cause of that extreme risk -perennial loose monetary policy- will not stop. In fact, it will be used as the solution if there is a market collapse.
Central banks should be tapering already, and if they believe that low sovereign yields are justified by fundamentals, let markets prove it. If negative nominal and real yields are justified by the issuers’ solvency, why is there any need for monetary authorities to purchase 100 percent of net issuances? Reality is much scarier. If central banks started tapering, sovereign yields would soar to levels that would make many deficit-spending governments quake. Therefore, by keeping yields artificially low, central banks are also sowing the seeds of higher debt, lower productivity, and weaker growth—the recipe for crowding out, overcapacity, and stagnation.