The age of near-zero interest rates continues – but at what cost?

Interest rates in the developed world are still at record lows and seem set to go even lower. What happened to central bank monetary tightening foreseen at the beginning of this year? Victor Hill enquires.

A historical anomaly

For the first five decades of my life the Base Rate in the UK fluctuated between five and seventeen percent. Yet in my sixth decade, further to the great financial crisis of 2008-09, rates didn’t get above one percent. Over the very long term, since the UK central bank, the Bank of England, was founded in 1694, rates have never been so low for so long. It is a very similar story in much of Europe and North America. This is the most striking characteristic of the modern global economy: we are living in the age of near-zero interest rates (at least in the developed world).

At the beginning of this year it looked like interest rates, led by the Federal Reserve of the USA, were heading higher. But the rate hikes anticipated by the futures markets didn’t materialise. Instead, after a relatively brief period of fiscal tightening over 2016-18, the Fed indicated on 10 July that lower rates may be necessary – and in the UK no one expects rates to rise much any time soon. In Europe, the ECB has abandoned the hawkish fiscal rhetoric of the first quarter of this year.

If I could comprehensively explain how and why the age of near-interest rates came about and how it was sustained, I would probably win the Nobel Prize for Economics. And if I could predict precisely when and why interest rates will return to historically “normal” levels, then I would probably command a fat salary from a hedge fund. Alas, I can do neither. But I can set out some ideas about what has been going on and in which circumstances things could change.

Alice in Wonderland economics

Back in May 2016 I wrote in these pages about the Alice in Wonderland economics in which a lender pays a borrower for the privilege of lending them money. This defies all economic logic and yet, if anything, the Mad Hatter’s tea party has got zanier still since then. The yield on 10-year German (government) Bunds fell to minus 0.407 percent last week. That means that the pension funds (your pension fund, perchance) and other institutional investors which buy these instruments are paying the German state nearly one half of one percent per year for the privilege of financing them.

Globally, right now about $13 trillion of government and even corporate bonds are trading at negative yields. How on Earth can that be? The principal explanation is that a flight to quality has meant that institutional investors have dumped less favoured investment papers and sought refuge in bonds with zero default risk. (But do Bunds really promise zero default risk? I’ll explore that question another tine.)

But, hang on. A flight to quality is the characteristic of a major financial or economic melt-down like the Asian debt crisis of 1997 or the Credit Crunch of 2008. When I last looked there was no financial crisis going on: in fact Wall Street has been hitting record highs these last few weeks. Although global growth is down this year, China is still growing at a clip of 6.2 percent and global employment has reached record levels. Indeed the FTSE-All World Index is up by over 15 percent this year. The UK market appears to be the victim of the twin fears of a disorderly Brexit and the Corbynisation of the economy.

Moreover, there is a plethora of high-yield stocks to be had in London – why a pension fund would want to spurn National Grid (LON:NG) with its solid 6 percent yield in favour of negative yielding French Trésor papers is beyond me. (France is the fourth most indebted country in the world with a debt-to-GDP ratio close on 100 percent. The country last ran a budget surplus in 1974 – before President Macron was born!)

What has distorted the markets, of course, is nearly a decade of quantitative easing (QE) – money printing – which was supposed to have come to an end by now but which is now back in vogue. Madame Lagarde, in anticipation of her new role in Frankfurt as ECB President, and Mr Johnson in anticipation of his in Downing Street, are no doubt frantically reading the Ladybird Book of Post-Modern Monetary Policy as I write.

I have written extensively before in these pages about how monetary policy evolved after the collapse of Lehman Brothers on 15 September 2008. For brevity, I’ll just say here that the original intention was to create liquidity in the financial system at a time when banks were obliged massively to contract their balance sheets (thus reducing the money supply). Unchecked, that could have led to widespread deflation. But, thereafter, the central banks took it upon themselves to engage in what Keynesians call demand management at a time when there were huge constraints on fiscal policy – i.e. to stimulate the economy. Since then, central banks have assumed the role of guardians of economic well-being – regardless of what elected governments determine.


A recent research paper by the ECB made the case for further interest rate cuts deeper into negative territory. But there could be political resistance to that. Frau Merkel’s anointed successor, Frau Annegret Kramp-Karrenbauer (known as AKK for short – who has just been nominated as the new German Defence Secretary) recently expressed the view that savers – especially the elderly – had been penalised for too long by near-zero interest rates. Ultra-low rates penalise the provident while indulging the profligate. Of course, if interest rates in the eurozone were to rise significantly then a swathe of southern European governments would go bust almost overnight.

When central banks carry out QE they vacuum up large quantities of government and corporate bonds: the excess demand then drives bond yields lower (the more in demand a borrower’s debt papers are, the less it has to pay to issue them). Demographics are also an important factor in the bond markets. The increasing proportion of citizens over 60 years old has bought with it a global savings glut with too much cash looking for a home. (I admit that phenomenon is not too evident in the UK and the USA where savings ratios have been falling since the financial crisis.) All this has artificially distorted asset prices – most evidently in the bond markets.

The thorny issue of central bank independence

In the Keynesian model of the economy the interest rate must, over time, be a rate that sets savings and investment in equilibrium. (Actually, Keynes argued in the General Theory (1936) that savings always equal investment since any expenditure on investment must be financed by saving somewhere in the financial system.) But until the 1990s, in most countries the level of the national benchmark interest rate was determined by a politician – namely the Minister of Finance. America was exceptional in that the interest rate has been determined by the Federal Reserve since it was established in December 1913 – and not the President of the USA.

This gave politicians the chance to manipulate interest rates for their own short-term electoral advantage rather than for the long-term good of the economy as a whole. By the 1990s the view became widely accepted in Europe that monetary policy – including the setting of interest rates – should be conducted by financial experts in the central banks. The UK was the last of the G-7 countries to give “independence” to its central bank when Gordon Brown, the newly appointed Chancellor, handed over control of interest rates to the Bank of England in 1997.

For the last 20 years the received wisdom has been that monetary policy should be left to the disinterested boffins: politically partisan ministers of finance should only set a “target” for the level of inflation as a framework for the central bank’s monetary policy. But since the financial crisis (and since the 1990s in Japan) the main risk to the economy has been not inflation but deflation. The inflation target of two percent per annum in the UK has hardly been exceeded during this period.

I have never been convinced that sharp-suited experts would do a better job of monetary policy than the cunning politicos. Giving away control of monetary policy to unelected “experts” is part of a global trend over the past 30 years according to which politicians have sought to outsource responsibility of one kind or another to quangos, national institutions and supra-national agencies. I am writing a book about this because it is important and little understood. If democratically elected politicians give their powers away and just shrug their shoulders when voters don’t like the outcomes saying “It’s nothing to do with me, mate” – then democracy is dead. (That was the main reason why I became a Brexiteer – but let’s not go there now…)

Anyway, in those 20 years or so the unelected, secretive and essentially unaccountable central bankers – what I have called the priestly caste – have arrogated to themselves effective control of the global economy and have taken monetary policy in a direction which the relatively youthful Mr Brown could not have imagined in 1997. At their secret confabulations in Jackson Hole and Davos they orchestrated a policy of near-zero interest rates PLUS a massive programme of QE without ever being called to account for the consequences of those policies.

When the asset price bubble pops across the western world (as surely, eventually, it will) the people will blame the politicians; the politicians will blame the central bankers; and the central bankers will blame the economists…

Politicians hit back and squeeze the central bankers

Even in the US, presidents have not been immune from trying to influence monetary policy. President Lyndon Johnson is alleged to have pushed William McChesney Martin (the longest serving ever Chairman of the Fed) against a wall over his interest rate policy. President Richard Nixon (“Tricky Dickie”) pressured Fed Chairman Arthur F Burns to cut rates in the early 1970s. President HW Bush bullied Alan Greenspan to cut rates – and even blamed him for losing the presidency to Bill Clinton in 1992. This year Jerome (“Jay”) Powell has been subject to almost daily invective from the President via Twitter.

Mr Powell was appointed by Mr Trump in February 2018 to replace Ms Yellen for whom the president apparently lacked esteem. Fortunately for Mr Powell, as he reminded a press conference last week in Washington, the president does not possess the constitutional authority to fire him. He was given a four-year term – and he told journalists that he firmly intends to serve it out.

He is more secure than the former Governor of the Central Bank of the Republic of Turkey, Murat Çetinkaya, who was fired by Turkish strong-man leader President Recep Tayyip Erdoğan in the wee hours of 06 July. He is the first central-bank governor to be fired in Turkey since the military coup of 1981. Mr Çetinkaya’s peremptory removal unsettled the markets. Mr Erdoan compounded the damage by proclaiming that high lending rates were fuelling inflation (an economically risible proposition) and proclaiming that it was he who was in charge of monetary policy.

In India, the independence of the central bank is also under threat. Viral Acharya, deputy governor of the Reserve Bank of India, resigned six months before his term was scheduled to end after Mr Modi was re-elected in late May[i]. India’s central bank governor Urjit Patel resigned from his post citing “personal reasons” last December[ii]. In similar fashion, the independence of the central bank of Japan has been eroded under Mr Abe’s premiership.


Even here in the UK out-going Chancellor Philip Hammond has warned that the choice of the next Governor of the Bank of England should not be politicized. (Mr Carney will step down in January and, reportedly, has advanced his name as a candidate to be the next President of the IMF.) Mr McDonnell has suggested that the new Bank of England Governor should be an instrument in the radical Corbynisation of UK society.

But those who would like to re-politicise monetary policy (and to contain the priestly caste) have an important point. Nobody voted for asset price inflation by esoteric means – which benefited only the rich.

Last week the US president said that he would nominate Christopher Waller and Judy Shelton to the board of the Federal Reserve. Both apparently favour lower interest rates and Ms Shelton has advocated a return to the gold standard (something which Mr Trump favours). As I shall share soon, a move in the direction of state-sponsored cryptocurrency may be equivalent to a return to the gold standard. Remember that the gold standard lasted for nearly 70 years – during which interest rates hardly changed at all.

Surely the next phase of populism (though as regular readers will know, I hate that term because populists are really old fashioned conservatives) will be to re-democratise the central banks by bringing them back under the control of the ministries of finance. Economic policy today is divided between fiscal policy (taxes and expenditure) and monetary policy (interest rates and money creation). Why should fiscal policy be the fief of elected politicians while monetary policy (now incorporating demand management) remains that of esoteric magi?

Where next for the ECB?

One major headache for the incoming ECB President, Madame Lagarde, is that Mr Trump has already accused the ECB of currency manipulation – with the implicit threat of reprisals.

But the course is already set. Signor Draghi said in Sintra in June: “Unless the eurozone starts to recover, additional stimulus will be required”. But voices in Germany demurred. As the Japanese experience since the early 1990s has demonstrated, it is very hard for an economy with near-zero inflation and a structural trade surplus (i.e. the eurozone) to stop its exchange rate rising unless it resorts to some kind of currency warfare. That is what Mr Trump is on about.

It will be difficult for Madame Lagarde to follow Signor Draghi’s July 2012 strategy of “whatever it takes”. In fact her room to manoeuvre is limited given the extreme fragility of the European banking sector (not least Germany’s – the nightmare at Deutsche Bank (ETR:DBK) has only just begun) and trade tensions with Trump’s America.

She has been appointed for her communication skills rather than her prowess in monetary economics. She is a City lawyer by background; Signor Draghi was a Goldman Sachs alumnus. She will need as much luck as Mr Johnson.

Towards the inflection point

Reliance on QE since 2008-09 has led to a surge in debt levels across the board. QE is itself a kind of financial engineering – which, most analysts will tell you, was the underlying cause of the great financial crisis. That happened essentially because risk and return became decoupled. The problem is that the global economy is now acutely sensitive to monetary tightening – a return to historically “normal” levels of interest rates would trigger recession. Put simply: we have become addicted to cheap money.

Leveraged lending (defined as loans to firms with debt at over four times cash flow – which are often, in banker-speak, “covenant-lite”) and shadow banking are back – big time, due to the frenetic search for yield. Shadow banking embraces finance companies, hedge funds, and all kinds of intermediaries.

The Bank for International Settlements (BIS) recently commented that the world has proven “unable to jettison its debt-dependent growth model”. While banks have been required to bolster their capital ratios under the Basel III framework (and equivalent regulatory tightening in the USA), risks have been transferred to the non-banking sector, which is now more than half of the global financial system. The ratings agency DBRS has warned of “significant risk” in the US shadow banking sector.

The BIS is also concerned about the growth of closed-end funds (now sitting on $30 trillion of assets worldwide) which invest in highly illiquid assets. You only have to consider the Woodford catastrophe to grasp that one – but I defer to my expert colleague Nick Sudbury for guidance on that.

The real issue is that, thanks to the priestly caste, the markets have become detached from economic reality – especially in the US market which seems to be impervious to the global slow-down. The Japanese, European and UK stock markets are cheap by comparison. But their debt markets are irrational.

Gold, be it noted, was up 11 percent on the year to the end of June when it hit a six-year high. This might suggest that investors fear a return of inflation – which is not what the money markets foretell. But if investors feel confused, I suspect the priestly caste does too.

I wonder though if the rise of cryptocurrency could be the catalyst that brings about the end of the age of near-zero interest rates…I’ll have something to say about how the adoption of Facebook’s new crypto-currency could ignite an explosion in the financial system in next month’s MI magazine.

Victor.Hill@masterinvestor.co.uk

[i] See: https://qz.com/india/1651181/reserve-bank-of-indias-viral-acharya-quits-as-deputy-governor/

[ii] See: https://www.bbc.co.uk/news/world-asia-india-46506275