Since the financial crisis of 2008, central banks in Europe and the US have reduced short-term interest rates to almost zero. The precedent for this was set by Japan, where rates have been at or below 0.5 percent since 1995. The world’s financial system is on a dollar standard, which means that the US monetary policy is the principal determinant of monetary policy elsewhere. As long as US rates are so low, interest rates in other countries will be artificially depressed.
The euro zone can’t set rates at, say, 3 percent without attracting vast capital inflows, which would force up the euro exchange rate, creating huge deflationary pressures.
Zero interest rates constitute a formidable challenge for investors. Money acts both as a medium of exchange and a store of value. The latter is critical to the savings process. How does one invest savings when central bankers are actively compromising money’s role as a store of value? There’s no easy answer. Short-term interest rates reflect policy choices of central banks.
The history of the US three-month interest rates since 1966 is seen in graph one. Zero rates are totally abnormal. There is only one precedent in the late 1930s. For investors, it’s not only the absolute level of rates that is key. They also look for real rates. By real rates we mean the interest return less the inflation rate. Positive real rates compensate investors for inflation. Negative real rates don’t. The history of US real rates is shown in graph two.
Monetary policy prior to 2008 evolved from the inflationary crisis of the 1970s (graph three). Post-war global inflationary pressures were subdued. Rapid growth came with productivity, which allowed a substantial growth in wages without pushing up prices. But by the end of the 1960s the further productivity gains ran out as government spending rose inexorably.
Government spending is inherently inflationary as governments use resources less efficiently than the private sector. For structural reasons world economic growth started slowing from 1968. This was politically unacceptable and many governments increased fiscal deficits and monetary stimulus. Without compensating productivity gains this stimulus mutated into inflation. Add a fivefold rise in oil prices after the 1973 Middle East war, and you had an inflationary explosion lasting a decade. By 1979 the US inflation rate hit 14 percent.
As governments proved unable to manage monetary turbulence, ideas were required on how to control inflation. They were found by economist Milton Friedman’s two key contributions. His dictum that inflation is a monetary phenomenon has become the mantra of theorists. If central banks controlled growth in money supply, they’d create price stability. At the end of the 1970s the US Federal Reserve tried to implement what Friedman recommended. The outcome was disappointing as interest rates became volatile. So the Fed fixed short-term rates higher than inflation. This formula of real rates worked. Initially, high rates created a recession that crushed inflation. Thereafter, money’s real cost made people use it productively. Monetary policy was no longer inflationary. For the next 27 years a new mantra permeated policy: real rates.
But the key reason inflation was tamed was Friedman’s second contribution. He was a great proponent of free markets.
The role of free markets in creating the benign global inflationary environment of the past three decades was critical. The key driver of price stability is not policy, it’s productivity. Economic growth is characterised as the process of making things cheaper. Since the 1980s, globalisation and expanding world trade have brought down prices. Free markets forced firms to compete aggressively. A wave of technology created products that cut costs. Allowing markets to operate without massive intervention controlled inflation.
But credit for this achievement was given to central bankers. Friedman’s dictum that inflation is monetary gave birth to the proposition that banks could control inflation. Inflation-targeting mandates became fashionable. But while inappropriate policy may cause inflation, it’s just a subset of a bigger picture. Appropriate policy is necessary, but not the only condition for price stability. Alas, central bankers, being human, took more credit for the decades of price stability than they deserved.
The first warning that price stability had origins more complex than money creation was in Japan where for two decades the government has been combating deflation with lavish deficits, money creation and zero interest rates. Quantitative easing was invented there. But these measures failed to kick-start the Japanese economy.
Despite Japan’s failure, others adopted similar ways to boost economies after 2008. US government officials argue that Japan should have spent money more aggressively. They maintain that the policy was correct but the application was wrong.
In Europe and North America, rates have been slashed. Money has been pumped into the system. Real rates have been abandoned. The proponents of zero rates argue that they stabilise the economy, relieve pressure on highly indebted consumers and encourage investment. A new reason is that low rates make it easier for governments to fund over-large deficits.
But unnaturally low interest rates have costs. They distort the pricing of asset markets, creating a misallocation of resources. The failure of the Fed to to rein in the US housing bubble is an example.
Perhaps the most pernicious effect of zero interest rates is on savers. “Financial oppression” describes impositions of governments on citizens and taxpayers. An example is zero interest rates. Savers are made to support the previously imprudent. Old people are the main victims. At this stage it is difficult to see the benefits of this policy. Some argue that, had rates been allowed to bottom at say 3 percent instead of zero, growth may have been no different to what’s happened without these social costs.
It is noteworthy that the policy of zero rates is attracting increasing criticism. This has not stopped the Fed from stating that rates will be at zero into 2014. But the tide of opinion is turning against the policy. And change in direction may happen sooner than banks and markets believe.
Already the US economy is surprising on the upside, probably not due to the actions of the Fed but rather due to normal economic processes which cause recoveries, improving balance sheets and a repricing of mispriced assets. A recovering US economy will undermine the Fed’s ability to sustain a regime of mispriced interest rates, both politically and economically. If the Fed raises rates in due course, Europe will have to follow suit.
Traditionally, rising short-term interest rates undermine the valuation of equities and long-dated bonds. This does not necessarily mean equity prices will fall, but rising interest rates will slow appreciation.
Since mid-2011 the base interest rate set by the SA Reserve Bank has also been lower than the inflation rate. What is an appropriate interest rate for South Africa is also likely to become the subject of debate. However, we have not experienced the financial oppression prevalent in Europe, the US and Japan. South Africa has had positive real rates since 1988. Only in the past six months have they gone negative.
A change in global rates is likely to affect South Africa through capital flows and the exchange rate. In recent years there has been a large foreign investment into our bond market. Attractive rates elsewhere may reverse this trend and put downward pressure on the rand. This in turn will create inflationary pressures that require higher interest rates. South Africa is unlikely to escape the effect of rising global interest rates.
Sandy McGregor manages fixed interest and individual client portfolios at Allan Gray.