A long standing Fed President, William McChesney Martin, kept saying that the central bank is like a good chaperone at a party: one that cares that the guests always have enough punch in their glasses. When the atmosphere gets too hot, the punch bowl must be taken away. If spirits are low and the guests are floating about sluggishly, punch must be topped up.
Talking about punch, McChesney Martin – who held the office under five different US Presidents, 1951 to1970 – obviously meant general monetary conditions in the economy, which the central bank may steer using interest rates and providing additional liquidity. The lower the current and expected central bank rates the lower the cost of loans and more favourable valuation of assets (including valuation of collateral, which may also stimulate lending).
Low interest rates do not only reduce the cost of corporate loans, but also boost asset price increases, including house prices. Indeed, in the US, house prices have increased, which partially eased the households’ concerns about the future financial situation, gradually reviving consumption.
Providing commercial banks with liquidity through purchasing their securities meant relieving them of balance sheet losses, which they could have suffered in consequence of successive price falls in the financial markets. This in turn reduced bank’s liquidity and solvency concerns, which should facilitate lending again.
Central banks hope that – historically unprecedented – easing of monetary conditions will help all recent party attendants recover after partying on credit, which overstretched unreasonably and did not do the guests any good. Since none of them feels well now – households are heavily indebted and banks must sort out their balance sheets – the healing measures applied by central banks to the economy cannot heal anyone fast.
Nevertheless, central banks do hope that quantitative easing (QE) will lift the spirits of consumers and enterprises, ease access to loans and reduce their cost, increase price competitiveness of domestic products and will ultimately boost economic activity. And indeed – some signals demonstrate that the macroeconomic situation in the developed world, also the US, has begun to improve recently.
The dangers of the low interest rate policy
The improvement of the macroeconomic situation – which is still quite shy – demonstrates how strong the impact of interest rate control on the economy can be (especially if – as was the case recently – central banks are trying to influence not only short-term interest rates but the entire yield curve).
However, it cuts both ways: the very fact that a proper adjustment of interest rates can help the economy a lot also means that it can hurt if done improperly, e.g. if interest rates are cut too much. In particular, central banks should bear disruptions in the financial markets in mind which can be sparked by too low interest rates.
In this regard, we can name three types of threats: (i) risk valuation disruptions and undesirable changes in business models; (ii) interest rate risk accumulation and transfer of income to arbitrageurs; (iii) delays in necessary balance sheet adjustments.
Risk valuation disruptions and undesirable changes in business models
Low interest rates and low profitability of traditional asset classes may induce investors to increase their exposure in instruments which in normal circumstances would be rated too risky. With low interest rates, the value of collateral used by investors for fundraising is growing, therefore increasing leverage is becoming relatively easier. Also, since low interest rates are empirically strongly correlated with lower asset price volatility, the accommodative policy of the central bank may be accompanied by a reduction of typical risk measurements of market participants’ portfolios (such as Value at Risk, VaR).
In consequence, with low interest rates, the market participants’ propensity to take risk rises, which – despite the fact that it may be desirable in the short-term – in the long run increases the sensitivity of the financial system to growing volatility and possible price adjustments. Moreover, greater risk appetite may reorient banks’ business models toward commercial and speculative activity, which, considering a proliferation of financial sector experienced before the crisis, would definitely be undesirable.
Empirical research shows that if interest rates are low, lower-capitalised banks begin to take greater credit and liquidity risk (Ioannidou, Ongena, Peydró 2009, Jimenez Ongena, Peydró, Saurina, 2012). Low interest rate may also contribute to housing booms and the development of speculative bubbles (Sa, Towbin, Wieladek 2011). This creates the risk of financial crisis and recession, which usually in such situations appears deeper, and the following revival comes later and is more rickety.
Interest rate risk accumulation and transfer of income to arbitrageurs
Low short-term interest rates and relatively higher (e.g. by reason of sovereign credit risk) long-term interest rates create favourable conditions for arbitrage between yield curve segments (cheap short-term borrowing and long-term investment at a higher rate).
Increasing (by cutting interest rates) income of commercial banks from such carry trade on the yield curve (of which LTRO is an excellent example), central banks wished to indirectly improve earnings and the capital position of commercial banks. Unfortunately, as the old principle of political economy says, one usually gets more of what one subsidises. If central banks subsidise extreme maturity transformation of assets, they encourage banks to retain potentially greater mismatch of the maturity structure of assets and liabilities.
In the short run, i.e. as long as central banks offer financing on favourable terms, this is not a serious issue, however in the long-term it may lead to excessive accumulation of liquidity risk and interest rates risk in banks’ balance sheets. Consequently, the financial system may find it hard to deal with the tightening of monetary conditions, which, sooner or later, is inevitable.
To illustrate the situation, let us bear in mind that the euro area banks already have too many treasury securities in their portfolios. If – through short-term lending to banks – the ECB, like it or not, encourages them to purchase government bonds (in carry trade), the inevitable interest rate increases will create a problem for banks to adjust to the future government bonds price falls.
Delay in necessary balance sheet adjustments
The Japanese experience of the 1990s demonstrates that low interest rates may facilitate the financing of unprofitable investment projects (the so-called ever-greening). Banks are then motivated to roll-over loans to companies that cannot afford to repay the whole loan, however, they can afford monthly debt service. It is quite tempting in the short-term, since it helps banks pretend to have high capital adequacy (NPL write-off would reduce their capital), and firms are protected from bankruptcy. In the long run, however, the avoidance of necessary restructuring creates a danger of filling up the economy and the financial sector with “zombies”, which obviously reduces competitiveness, investment, and prevents new projects from entering the market.
Poland: interest rate cuts to the safe level
In Poland, in response to inflation drop below NBP target and economic slowdown, the Monetary Policy Council made a series of interest rate cuts, bringing the reference rate in July 2013 down to the historical low (2.5 per cent). The Council also declared that, in view of a low inflationary pressure and moderate scale of the expected revival, the rates would remain unchanged at least until year-end.
Given the dangers connected with low interest rates, the Council’s decisions may provoke a question whether the current interest rates in Poland are not too low.
In order to assess that, a universally recognised [natural rate] benchmark – the real equilibrium rate of interest – to put it simply – a rate that would settle in the ideal economy in which nominal variables play no role, would have to be consulted. The obvious problem with such approach is that there is no such a thing as the ideal economy, and all its models – such as the equilibrium rate of interest models – carry considerable uncertainty.
Luckily, not everything is lost and even if the equilibrium rate of interest is not directly observable, having its macroeconomic properties we can deduce how interest rates in the real economy move against it. Since it has the property that in our ideal model, it invalidates all nominal variables, in the real economy it would be a rate that would lead to perfect price stability.
The central bank can therefore conclude that – even if it does not know where exactly the equilibrium rate of interest is – it can be certain that if the real interest rates were permanently below the equilibrium rate of interest, we would have the intensification of inflationary pressure.
Yet, in Poland, YTD, inflation has continued below NBP inflation target of 2.5 %, with low demand-and-cost-induced inflationary pressure, and also with low inflation expectation level. All this fully justifies the Council’s interest rate cuts.
Let us not forget, however, that stabilising only the inflation and supply gap, which usually occurred before a crisis in countries applying inflation targeting, may turn out short-sighted. The seemingly stable macroeconomic situation may be accompanied by the development of financial imbalances, whose consequences for the economy are often very acute.
Narodowy Bank Polski is fully aware of the fact that, given the historical experience, the present interest rates in Poland are unusual, which follows partially also from unusually low interest rates in many financial centres worldwide. Therefore, we must be on special alert whether – while caring for the economy – we do not contribute to disturbances in the financial market. Our vigilance should be all the greater ad we still do not have any appropriate macro-prudential tools and institutions.
As we know, legislative work on the Systemic Risk Board) is still in its early days. And the existence of possible macro-prudential institutions could help the monetary policy, the interest rate policy to ease off tensions in the financial market.
All this leads to a conclusion that – as warned by McChesney Martin – a good central bank is a bank that knows when to remove the punch bowl. Today, in the mathematical world of economic models, the metaphor may appear somewhat outdated. This is, however, not the case, since models cannot fully incorporate the uncertainty of the future course of events in the economy, which makes the economic policy, including the monetary policy, remain largely an art rather than a mere mechanical observance of rules derived from the general equilibrium model.
NBP President, professor Marek Belka, delivered a lecture on 22 October entitled “Rynek finansowy a gospodarka niskich stóp procentowych” [The Financial Market And The Low Interest Rate Economy] during Warsaw International Banking Summit.