Physicians are required to take the Hippocratic Oath, “First, do no harm.” Evidently, there is no such oath for central bankers. The prescription for lower interest rates, and now in too many instances, negative rates, isn’t the remedy for what ails the global economy. On the contrary, low and negative rates just might be killing the patient. Just ask Japan or, more recently, Europe. Similar to chemotherapy and radiation, zero and negative rates aggressively attack the powerful cancer cells of subpar economic growth and below-target inflation, but with harmful side effects. And although at times it seems as if the treatments are working, the global economy cannot be described as fully cured from the disease.
Everyone has conveniently, and seemingly all at once, abandoned the belief that positive real interest rates are an important signal for a healthy economy. They provide a powerful hurdle rate discipline to corporate executives making long-term spending decisions and also deliver compelling incentives for savers. From my perspective, zero and negative interest rates are symptoms that still diagnose the global economy as sick more than a decade after the Great Recession.
Check the warning label
There are plenty of nasty side effects from zero and negative interest rates. Businesses have greedily stuffed their collective fists deep into their pockets, refusing to spend a dime on almost anything but repurchasing their own shares. Borrowing by both consumers and businesses has surged — piling up even more debt on top of an already huge mountain of debt. Low rates have penalized savers, hurt the banking industry’s profitability and resulted in growing wealth and income inequality. Potential asset price bubbles may also be forming. Look no further than the nearly $16 trillion in global debt with negative yields.1 The bull run in these bonds has been so spectacular that buying now and holding on until maturity guarantees the investor future losses. Yet, investors enthusiastically buy more!
Sadly, to the dismay of Chairman Powell and many others, zero and negative interest rates haven’t done much to permanently repair sluggish economic growth or reignite inflation. And yet they continue on the same path, making the central bankers’ motto, “If at first you don’t succeed, try, try again!”
Source: Bloomberg Finance, L.P., as of August 19, 2019.
The placebo effect
How can President Trump and so many economists be certain that lower rates are the solution to the US economy’s challenges? That policy hasn’t worked for Japan. It hasn’t worked for Europe, either. For example, today, the deposit rate of the European Central Bank (ECB) is -0.4%. The deposit rate is the interest rate that the ECB pays for deposits that banks hold at the central bank. It has been negative since June 2014. This means that banks have to pay for the balances they keep with the ECB. Will lowering the deposit rate to -1% revive Europe’s stalling economy and save its failing banking industry? I doubt it.
In the US, the lower-rate crowd’s faith is fueled by the following: The Fed’s target funds rate is among the highest policy rates in the world and, therefore, should be lowered to improve competitiveness with other countries. The Fed’s preferred inflation measure remains well below the 2% target. Economic growth has slowed everywhere, including in the US. Uncertain trade policy outcomes have increased recession odds. And, finally, the Fed has tightened too much by raising rates throughout 2018.
An equally compelling case can be made for keeping rates steady and at still very accommodative levels. Taking a simple average of GDP for the first two quarters indicates that the US economy is growing at 2.6%. As of August 16, the Atlanta GDPNow forecast estimates economic growth of 2.2% for the third quarter. These GDP numbers may be underwhelming, but they hardly suggest that the US economy is on the brink of recession. Moreover, the Bureau of Labor Statistics (BLS) reported in an August 13 news release that the core Consumer Price Index (CPI) that excludes volatile food and energy prices climbed 2.2% over the past 12 months, modestly above the Fed’s inflation target. The latest BLS employment data also implies a strong labor market. The unemployment rate of 3.7% is near 50-year lows, and wages grew by 3.2% year over year.
Both the Institute for Supply Management measures of manufacturing and services for July are greater than 50, demonstrating that the US economy continues to expand.2 The National Federation of Independent Businesses Small Business Optimism Index came roaring back, with 7 of 10 components advancing in July.3 And US stocks remain within spitting distance of all-time highs. So why on earth is the Fed cutting rates?
The Fed’s midcycle rate cut was a preemptive strike to protect the slowing US economy from Trump’s damaging trade wars. Powell’s July rate cut was also an indirect swipe at the president’s controversial approach to trade policy. Now, in a strange twist, President Trump and Chairman Powell have begun playing the blame game. Each claims their policies can’t be successful without some help from the other person. Bashing Powell almost daily, the president claims that the US economy is winning big time, and if the Fed would just do its part by aggressively slashing interest rates, the economy would soar even higher.
Feeling weak in the knees
Disappointing business spending remains a headwind to better economic growth rates. Gross private domestic investment tumbled 5.5%, the worst decline since the fourth quarter of 2015, as spending on structures slumped 10.6%. This decline pulled a full percentage point from the second quarter GDP number.
Market watchers quickly concluded that business spending was constrained by rising trade tensions between the US and China. It seems reasonable that uncertainty about the future rules of engagement would cause businesses to reduce their spending. However, business spending has been persistently weak throughout the long economic expansion — way before trade tensions between the US and China. Wait, I thought zero and negative rates were going to help bolster corporate executives’ animal spirits? Actually, we’re seeing the opposite effect. Corporate executives have become complacent and risk averse. Growing trade conflicts are only intensifying those feelings.
How corporate executives are spending unremitted corporate cash flows underscores this point. They only have a few choices: buy back shares, pay dividends, retire debt, pursue mergers & acquisitions, make capital expenditures, increase wages/hire more workers or save for a rainy day. In a zero and negative interest rate world, the easiest and safest choices are to buy back shares, pay dividends and save for a rainy day. On the other end of the spectrum, companies with weak business models can take advantage of low rates to borrow heavily. Their day of reckoning, and possibly ours, will come when interest rates finally rise, denying these fragile businesses access to the credit markets.
Reduced business spending, a harmful side effect of zero and negative rates, depresses productivity and weakens economic growth rates. Positive real interest rates provide a healthy hurdle rate for corporate executives’ long-term investment decisions. Without them, expect executives to continue to make the safest and easiest choices when it comes to capital allocation. That means weak business spending will likely remain an albatross around the neck of economic growth.
Someone call a doctor
Zero and negative rates are also destroying cash. When the Fed and other central banks push interest rates to zero or even negative in some instances there are clear losers. Low rates make it harder for savers to get a competitive return that might provide some financial independence today and a secure retirement in the future.
There was a time when simply rolling over Certificates of Deposit (CDs) at competitive interest rates was an attractive, conservative investment strategy for retirees. Sadly, those days are long gone, at a time when more than 43 million Americans, 13% of the population, are retired and receiving monthly payments from Social Security. Demographics in the US have shifted dramatically. The GIs who came home from World War II to rebuild the country, start families and live the American Dream were a decades-long catalyst for exceptional US economic growth and rising inflationary pressures. Now, however, the number of Americans retiring each day has nearly doubled since the year 2000. According to Deutsche Bank research, each day roughly 10,000 Americans turn 65, the standard age for retirement. Census forecasts find that number will reach nearly 12,000 in the next 10 years.4
Positive real rates could really help America’s fastest growing cohort. And advancements in medicine and longer lifespans together with greater income from positive real interest rates could result in an unexpected boom in their consumption that could increase economic growth. Ever see Ron Howard’s 1985 film, Cocoon? Perhaps retirees earning a healthy retirement income could provide a boost to the economy.
Just think about all the crazy medical treatments that have been used to cure the ill throughout history. For example bloodletting, the process of withdrawing vast quantities of blood from the body, was used until the late 19th century to cure just about anything. Today, we scoff at these wild remedies. Perhaps someday we’ll all have a good laugh at how politicians and central bankers tried to use negative interest rates to heal the economy and spark inflation.
I’ll let you in on a dirty little secret. You know who needs zero and negative rates? Politicians do — to keep interest rates low on massive amounts of government debt and empty promises on entitlement programs, like pensions, Social Security and Medicare. You know who else needs low and negative rates? Weak companies with poor business models and lots of debt. And so do overleveraged consumers.
We need to change our collective mindset and quit the feel-good addiction to ever-lower rates. Positive real interest rates are a sign of strength and health. We should all embrace them. Strong consumers and businesses don’t need your low rates, Mr. Trump, Mr. Powell and Mr. Draghi. You can keep them. Positive rates denote strength, provide healthy hurdle rates for sound business models making thoughtful long-term investment decisions, and give savers attractive options and income. Only when we have positive real interest rates will we know that the economy is truly healthy and that the Great Recession is finally behind us.
1Paul J. Davies and Patricia Kowsmann,, “Germany for First Time Sells 30-Year Bonds Offering Negative Yields,” The Wall Street Journal, August 21, 2019
2 Institute for Supply Management, July 2019 Manufacturing ISM® Report On Business, August 1, 2019.
3 NFIB, July 2019 Report: Small Business Optimism Continues to Defy Expectations, July 2019.
4 Kristin Meyers, “Americans are retiring at an increasing pace,” Yahoo Finance, November 21, 2018.
Bloomberg Barclays Global Aggregate Bond Index
A flagship measure of global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers.
Bloomberg Barclays US Aggregate Bond Index
A broad base bond market index representing intermediate term investment grade bonds traded in United States.
An approximate measure of a bond's price sensitivity to changes in interest rates.
Gross domestic product (GDP)
A monetary measure of the market value of all the final goods and services produced in a specific time period, often annually.