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The 300 Club on zero policy rates and painful devaluations

25 Nov 2020

Stefan Dunatov, chair of The 300 Club, comments on the potential long-term impact of lower central bank interest rates.

Over a decade since the great financial crisis, the global economy has been adjusting to a new significant external shock -Covid-19. As monetary and fiscal policy continues to be accommodating, the discussion has already shifted to low policy rates for much longer, and whether central banks and government are helping or hindering the economy in the long run.

The policy response to Covid-19, however, is part of an ongoing, broader decline in interest rates and reallocation of resources. Whether or not Covid-19 was part of the political and economic scene, interest rates were always going to stay lower for longer.

To help understand this, think of the financial markets as part of the broader economy. Despite financial market trials and tribulations, the global economy has enjoyed greater stability since the end of World War II.

Recessions occur less frequently, they are less damaging to domestic demand, economic expansions last longer and although wage growth has not been equally distributed it has still been positive.

Changes to the underlying economy are responsible for these outcomes. We operate in a more service-oriented economy, with less exposure to volatile manufacturing cycles. Our economy benefits from the disinflationary effect of technological changes that continually substitute or displace parts of the global supply chain.

As a simple example, an Economist article on airless tyres implies lighter cars, making them more fuel efficient, reduced costs due to lack of need for spare tyres and associated tools, longer-term cost reduction through use of 3D printing for tyre treads, and environmental benefits through the reduction in use of rubber tyres. This example is being continuously repeated across the globe at scale.

At the same time, government and central bank policy is being directed to a single cause: the sustaining of domestic demand growth, allowing policy makers to target maximum levels of employment.

Thanks to ongoing support for developed countries’ domestic demand, companies enjoy strong growth outlooks and equity markets have performed well, especially since the early 1980s, when central banks began to become more independent, thereby cementing the focus on sustaining
domestic demand and employment growth.

There is no ‘Powell Put’ – it’s a put on the whole economy, the value of which has grown exponentially as economic volatility has persistently fallen.

There has, however, been one looming problem: the need to transfer real assets from older, wealthier generations to future generations in the face of high asset valuations. The most obvious example is property. One way would be for asset prices to fall to the point that they become affordable for younger populations.

But this implies such a large fall in house prices for price-to-income ratios to become reasonable that it would be crippling to the banking system (which lends against all that property).

Moreover, it would demolish much of the wealth of the selling generation. Like a “painless” internal devaluation, zero interest rates are a long-term policy prescription to penalise wealth owners and subsidise the younger generation of buyers, to whom these assets will eventually be transferred.

Policy rates are not being set at zero by central banks with this in mind; they can only tactically
respond to the broader fall in interest rates being dictated by the economy at large.

Instead, policymakers, similar to the financial services sector which serves the real economy, are forced to reconcile how to accommodate a shift in asset ownership whilst keeping domestic demand growth stable. That requires zero or negative interest rates now and for many more years to come.

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