World markets may have recovered their poise from a torrid start to the year, but their outlook for global growth and inflation is now so bleak they are betting on developed world interest rates remaining near zero for up to another decade.
Even though the U.S. Federal Reserve has already started what it expects will be a series of interest rate rises, markets appear to have bought into a “secular stagnation” thesis floated by former U.S. Treasury Secretary Larry Summers.
The idea posits that the world is entering a peculiarly prolonged period in which structurally low inflation and wage growth – hampered by aging populations and slowing productivity growth – means the inflation-adjusted interest rate needed to stimulate economic demand may be far below zero.
As there’s likely a lower limit to nominal interest rates just below zero – because it’s cheaper to hold physical cash and bank profitability starts to ebb – then even these zero rates do not gain traction on demand.
For all the debate about the accuracy of that view, it’s already playing out in world markets, with long-term projections from the interest rate swaps market showing developed world interest rates stuck near zero for several years.
Take overnight interest rate swaps. They imply European Central Bank policy rates won’t get back above 0.5 percent for around 13 years and aren’t even expected to be much above 1 percent for at least 60 years.
Japan’s main interest rate won’t reach 0.5 percent for at least 30 years, they suggest, and even U.S. and UK rates are set to remain low for years. It will be six years before U.S. rates return to 1 percent, and a decade until UK rates reach that level.
“Although interest rates are low, they’re not accommodative,” said Harvinder Sian, global rates strategist at Citi in London. “The era of zero rates will be with us for years and years, it wouldn’t surprise me if we’re looking at another five to 10 years.”
The five countries or economic blocs currently with negative deposit rates have yields below zero on all their bonds from a minimum of five years’ maturity (Denmark) to a maximum of 20 years (Switzerland).
While some claim market pricing is far-fetched, similar doubts were expressed about zero interest rate policy and quantitative easing as the 2007/2008 crisis broke. Yet both are still being used and 46 central banks have eased policy since the start of last year, nine of whom have rates below 1 percent.
The ECB and Bank of Japan have already adopted negative interest rates on bank deposits, and are expected to loosen policy further via a mix of deeper negative rates and more asset-buying QE.
If the central banks guarding two of the four main world reserve currencies are easing, the exchange rate impact will tend to strengthen the other two, dragging on exports limit any interest rate rises there.
Japan’s prolonged fight to escape deflation is instructive. As the economy reeled from the collapse of the stock and housing markets, the Bank of Japan entered zero-interest rate territory in 1995 when it cut rates to a then record low of 0.5 percent.
More than two decades on, they’ve never been higher than that, despite near full employment and the largest debt burden in the world.
“Today’s risks of embedded low inflation tilting towards deflation … are at least as serious as the inflation problem of the 1970s. They too will require shifts in policy paradigms if they are to be resolved,” Summers wrote last week.
For many, Japan shows that huge monetary stimulus from the central bank doesn’t always lift inflation or inflation expectations, consumer or business demand, and ultimately overall growth – what’s known as the “liquidity trap”.
Joseph Gagnon, senior fellow at the Peterson Institute for International Economics in Washington and former Federal Reserve Board economist, warns against comparing every country to Japan.
Core inflation and employment in the United States are close to the Fed’s targets, and even in Japan the latest round of QE looks finally be bearing fruit in consumer prices, Gagnon said.
Still, he says there was little for policy complacency.
“Unless Japan and the euro area ease policy much more aggressively, they will likely be stuck with zero or negative interest rates for years,” Gagnon said.
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