When side-effects of financial medicine start to harm the patient

Since the Great Financial Crisis, most central banks have drastically cut interest rates and in some cases introduced the world to Quantitative Easing (QE): ultra-low (and in some cases negative) interest rates have become part of everyday life. And with only a handful of major central banks - including the US Fed - likely to even contemplate raising interest rates near-term, this is unlikely to change any time soon.

Central banks argue they had no choice but to cut rates - to all-time lows in many countries - and introduce QE to help stabilise economic growth, inflation and employment by lowering borrowing costs and indirectly boosting confidence and the price of assets, including housing and shares. There is evidence that this approach has worked to some extent.

Global economic growth has halved in the past five years but has not collapsed; unemployment rates have fallen, to below 5% in both the US and UK; the bogeyman of deflation has been avoided (for now). We will never know what would have happened had they not acted forcefully, but central banks administered aggressive and unconventional medicine and the patient is still alive.

 A number of European governments are considering their options, but all have serious drawbacks

Yet there is mounting evidence that the benefits of this experimental medicine are starting to fade: global growth is still running at half the rate it was in 2010 and any near-term improvement is likely to be modest. Rate cuts and QE have simply failed to materially boost lending, borrowing or investment. These unorthodox policies have squeezed banks’ profit margins which, perversely, have been less inclined to lend. Low rates of returns may have encouraged companies to hoard cash, holding back investment and much-needed productivity growth.

Now these unintended and increasingly potent side effects of very low rates are grabbing the headlines. 

Zero interest rates policies have arguably contributed to increased inequality, including between savers and house or share owners, fueling support for populist and nationalist parties in the UK but also across Europe and the US.

Large corporations and richer segments of society have enjoyed greater access to cheap and plentiful capital and been the main beneficiaries of buoyant equity and housing markets. Savers have seen interest rates on deposits dwindle to near-nothing.

Pension funds, already under pressure from aging populations, face a problem: returns on fixed-rates bonds, on which they rely to pay inflation-linked pension, have collapsed, often faster than inflation. Very low or even negative real rates of returns are making it increasingly difficult to balance their books and guarantee pension payments.

A number of European governments are considering their options, but all have serious drawbacks. Forcing companies to make big cash injections into their pension schemes could put pressure on smaller companies’ finances. Changing regulations to allow pension funds to invest in riskier assets may boost returns but also leave pension funds more vulnerable to market downturns. Cutting state benefits or raising the age of retirement - the latter has so far been the favoured option, including in the UK - will mean people having to work longer to get the same pension.

At the same time, job creation has typically been concentrated in lower-paid jobs, with growth in UK weekly wages averaging only 1.6 % per annum for the past seven-and-a-half years. To put this in context, UK wages have risen by only 14% since early 2009 but house prices are up a whopping 34%. For those on lower incomes trying to get on the property ladder this undeniable widening gap between wages and house prices is an increasingly tall hurdle to clear, particularly in large cities. The Nationwide’s affordability index, which measures mortgage payments as a percentage of mean take home pay, is currently around 34% or twice as high as in the mid-90s. In London the picture is far worse: the affordability index has surged to 67%, 20 percentage points higher than in 2009. The government’s measures to mitigate this deterioration in affordability ratios are - at best -  a partial solution.

Central banks and governments across the globe are having to re-think what they can and should do next

Post-referendum UK households and companies are also contending with an extra set of challenges: sterling has collapsed over 20% in the past year; Inflation is likely to rise which will further eat into real wages; the cost of a holiday abroad or purchase of a foreign property has shot up. A more competitive pound should help UK exporters but so far there is limited evidence this has happened.

Central banks and governments across the globe are having to re-think what they can and should do next. But the solutions are not straightforward or without costs. They may well change tact but there is no guarantee that interest rates will rise materially if economic growth does not pick up.

With central banks struggling to square the circle, governments are looking to increase spending, particularly on much-needed infrastructure. Both US presidential candidates have promised to boost such spending and British Prime Minister Theresa May is pushing ahead with large-scale investments in energy provision and transport. But popular opposition, pressure from vested interests and politicians’ focus on re-election can easily derail large-scale projects which often don’t bear fruit for years or are simply not financially viable.

Olivier Desbarres

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