Central bankers, the world over, share a conviction when it comes to interest rates. If there’s one thing that unites them, it’s the belief that the lower the rates, the better.
For much of the last decade, the banks have been on a monetary easing binge. Some banks, like the US Federal Reserve, have lowered rates to near zero. Others, like the European Central Bank, have taken things to a whole new level. Following the ECB’s lead, a number of European central banks have lowered rates into negative territory. That’s forced many commercial banks to pass these negative rates onto customers.
Our own Reserve Bank has been on a similar path recently. It’s progressively lowered the cash rate from 7% in 2007 to 1.85% today.
The merits of these aggressive rate policies trigger debate about their overall impact. Do economies actually benefit from lower rates in the long run? Or are they merely a short term stimulus, doing more damage in the long run?
Bill Gross, a renowned financial manager, believes low interest rates ultimately cause more problems than they solve. He says that rock-bottom rates aren’t the answer to fixing the US economy post-GFC.
And he’s right, of course. Mr Gross is referring to the US, but he may as well be talking about Australia.
Central banks: the problem with monetary easing
Central banks lower rates with one major purpose in mind. By making credit cheaper to access, they lower borrowing costs for businesses and consumers.
In theory, this provides an economy the platform to undertake a spending-led recovery. In practice, what we end up with is excessive credit, inflation, and asset bubbles.
What’s more, low rates make most consumer goods less affordable. Consider Australia’s current predicament. Borrowing has never been cheaper, but housing affordability has never been worse. We have more money, but it doesn’t take us as far it should. All this does in the long run is increase the inequality gap.
Ultimately, credit expansion sends bond and stock P/E ratios through the roof. But it does so without addressing any underlying issues with the economy.
According to Mr Gross, the Fed is seeing the error of its ways. That’s pushing it to reverse its rate policy, starting with an imminent rate hike.
I’m not entirely convinced they didn’t know exactly what they were doing. Regardless of how the mainstream paints these bankers, they’re not fools. Their policies are very coordinated. More than anyone, they know that credit expansion mostly leads to temporary, not lasting, gains.
They also know that only a private sector investment spree has the kind of heft behind it to make the effects of rate cuts lasting. They can invest in projects, and hire people, to boost real economic growth.
Yet businesses haven’t gotten the message. Their reluctance to invest leaves most of the benefits from cheaper credit flowing towards assets like stocks.
From the US to Australia, business spending is lacklustre at present. As Mr Gross puts it, corporate investment in the US has been ‘anaemic’. But companies are not completely missing out on the benefits of cheaper credit.
They’ve been happy to borrow money to fund things like share buyback schemes. And why wouldn’t they? If profits aren’t growing, then buybacks make for a handy substitute. That’s exactly what we’re seeing. According to Mr Gross, the rate of buybacks is only increasing.
‘Corporate authorisations to buy back their own stock [amounts to] US$1.02 trillion so far in 2015. [That’s] 18% above 2007’s record total of US$863 billion’.
Does any of this sound familiar? It should, because it’s the same thing that’s happening in Australia. Aussie companies like Rio Tinto [ASX:RIO] have recently undertaken buybacks to appease investors. Meanwhile, the banking sector leads the way with aggressive dividend policies.
Granted, commodities exporters aren’t the problem as far as lacklustre investment goes.
The non-mining sector is less immune to criticism however. Their reluctance to invest is taking its toll on the economy. And why is the non-mining sector not investing?
The reason has little to do with borrowing costs. Instead, these businesses expect higher returns on their investments. That actually works in the favour of smaller competitors.
The effects of this are clear for all to see. Smaller companies that have no business staying competitive use cheap borrowing costs to stay afloat. Mr Gross explains:
‘BB, B, and in some cases CCC rated companies have been able to borrow at less than 5%. A host of zombie and future zombie corporations now roam the real economy’.
This same situation is playing out in Australia too, albeit to a lesser degree. These zombie corporations aren’t beneficial to the economy. They flood the market with unwanted supply, lowering profit margins for the bigger players. In the case of iron ore, it leads to the situation in which the major players flood the market with supply just to maintain market share.
But that’s not where the negative effects of lower rates stop.
Another consequence of cheap credit is that it squeezes interest margins among banks. These margins describe the difference between interest inflows and outflows. A negative interest margin is where banks make less in interest than they pay out.
At the same time, low interest rates cause issues with mispricing across all financial markets. That’s true whether it applies to stock prices or commodity prices.
Fed to lift rates in September?
Mr Gross expects the US Federal Reserve to start lifting rates in September this year. He explains:
‘There is no statistical reason per se for the Fed to raise interest rates. It won’t come because of a risk of rising inflation or the unemployment rate, which in July fell to 5.3%’.
The latest figures coming out of the US show the economy grew at 2.3% in the second quarter. That came in lower than earlier estimates, which had penned growth at 2.5%. But the numbers are being described as solid. The reason for the uptick was put down to a rise in consumer spending. That’s important as consumer spending makes up 70% of economic activity in the US.
It’s unclear whether this is enough to tip the scales in favour of a September rate hike. But the market consensus still points towards an imminent rise.
Mr Gross hopes the Fed will kick-start a chain of rate hikes. That would begin to weed out the zombies in the economy.
Unfortunately for Australia, the Reserve Bank is waiting for US rate hikes for all the wrong reasons. They’re still looking for any help they can get to push the Aussie dollar down…anything to get a leg up in the world’s race to the bottom.
Contributor, The Daily Reckoning
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