In mid-2019, a third of investment-grade bonds including government bonds – worth US$17 trillion – had negative yields. Compare that with now.
US 10-year Treasury yields, which fell as low as about 0.55% in 2020, have topped 5.20% in recent weeks, as investors fret about inflation and Washington’s strained public finances, and investors redirect money to fund infrastructure tied to artificial intelligence.
UK 10-year Gilt yields have almost reached 5.5% as London’s debt topped 3 trillion pounds for the first time. French 10-year government bond yields have breached a 24-year high of 5.1% due to concerns about Paris’s debt sustainability and the country’s political instability. Australian 10-year bonds are trading around 5.25% even though Canberra’s deficit and gross debt are modest compared with peers.
These are the four advanced countries whose 10-year government yields have recently exceeded 5% amid a worldwide surge in sovereign yields to decade highs. Needless to say, as benchmark government yields climbed, interest rates for consumers and business have soared too.
It can safely be said that the era of low interest rates has ended. One upshot is the era of promiscuous monetary policy can be assessed for its benefits and costs.
Recall that after the global financial crisis of 2008, central banks cut key rates to record lows – including below zero for the first time, promised to keep these policy rates low for years and conducted massive asset-buying to reduce the yields of all maturities.
Central bankers took such steps even though they knew that interest rates as a macro tool lose their stimulus fizz when they are close to zero, let alone if they are even mildly negative.
UK economist John Maynard Keynes in 1936 spoke of the 'liquidity trap' when describing the limits of low interest rates as an effective policy tool. He stated how uncertainty could be so great even low interest rates would fail to generate enough demand to ensure full employment.
While Keynes was indicating that low interest rates could be ineffective as a macro tool, the bigger worry is ultra-loose monetary policies produced side effects that made them counterproductive. Ten side effects stand out.
One is that Keynes’s liquidity-trap concept seems to underestimate the dampening effect of emergency measures. Low rates seem to dent consumer spending and business investment because they signalled that authorities were gloomy, even panicked.
A second side effect is that low interest rates encouraged so much borrowing that business, consumer and government debt soared to record highs in nominal terms. As a proportion of GDP, they collectively amount to 310% of global output. At some point, the debt build-up must unwind and pose a systemic risk. Even without such mishaps, future repayments are likely to reduce the consumption and investment that drives economies.
A third side effect is that low and negative rates super-charged the price of assets. This always risked future trouble because if low and negative rates help the economy as intended bond yields must move higher and puncture asset prices.
The fourth side effect is soaring asset prices especially for housing widened inequality between asset owners and others, complicated by the fact that people were forced to heavily mortgage themselves to own ever-more expensive homes. It’s not a stretch to say that the resentment from how low interest rates have indebted one generation of homeowners – they are most at risk from higher rates and a housing crash – and pushed housing beyond the reach of later generations is fanning the populism that troubles so many countries today.
A fifth problem is that low and negative rates troubled the business models of insurers and pension funds that typically use the safety and positive returns of government bonds to help meet long-term liabilities (that, in Europe especially, are often income guarantees). A sixth spillover was that low and negative rates squeezed bank margins, sometimes to the point of threatening financial stability, even when asset values on balance sheets rose and bad debts were generally lower.
Any crimping in bank margins brings a seventh problem; that at some level, low rates could backfire by forcing banks to restrict lending – a level known as the ‘reversal rate’.
An eighth handicap is that central banks have faced political pressure for hurting savers and rescuing reckless borrowers. This could have undermined their independence to control consumer inflation. A ninth side effect is low and (especially) negative rates, perversely again, forced people to save more to attain a targeted level of savings. In such cases, low rates were a drag on growth.
A tenth drawback is that low rates encouraged unproductive investment and preserved zombie firms, which reduced productivity, a problem that plagues living standards today. If money has no ‘time value’ – the concept that money is worth more now than in the future – there is no hurdle for investment and firms struggling to earn their cost of capital don’t collapse, which impedes capitalism’s creative destruction. Negative interest rates, in fact, send this ‘time value’ concept haywire.
These risks might explain why low rates often failed to spark sustainable economic growth. The question arises as to whether such risks are worth taking to fight mild deflation which, in economic effects, is not much different from negligible, or zero, inflation.
If such a world were to reappear, policymakers should rely less on hyper monetary stimulus. In the meantime, the world is struggling to cope with the damage wrought by decades of the lowest interest rates in history.
It must be noted that central bankers have largely kept their economies at full employment, an achievement that avoids much social cost. But they seemingly brushed aside the longer-term costs of doing that. Another thing to note is that real interest rates are more critical economically than nominal ones. Low nominal rates essentially failed to bolster economies because they never approached the negative real rates that stimulated economies over much of the 1940s to the 1970s. That said, low nominal rates helped stoke some economic growth. For all their side effects, no upheaval occurred during the era of low interest rates.
But even with these qualifications, central bankers appeared to see the side effects their ultra-loose monetary policies provoked. They were among the most vocal in calling for instruments other than monetary policy to lead the world back to prosperity.
Michael Collins is a freelance writer and editor, economist, and investment specialist. Republished with permission from the author’s Substack newsletter @denouementwatch.