Commentary

Interest Rates: The Zero Percent Solution


The saying of radical things is easy sport among central bank watchers. If they're wrong, the wave of consensus erases most evidence they ever said anything at all. If, however, a wild, contrary call proves right, the rewards can be spectacular.

Which is not to say that the first crop of contrarians calling on the world's central banks, particularly the Federal Reserve, to initiate higher borrowing costs are fueled by anything other than conviction. Raghuram Rajan, a former chief economist at the International Monetary Fund who is a professor at the University of Chicago's Booth School of Business, saw the credit crisis brewing in 2005; he now says Fed Chairman Ben Bernanke should gradually increase his benchmark interest rate by as much as two percentage points. William White, who used to head the monetary and economics department at the Bank for International Settlements, is warning that "low rates are not a free lunch, but people are acting as though they are."

Keeping rates too low for too long damages the recovery by "raising asset prices and incentivizing investment in riskier assets," according to Rajan, which threatens to create yet more bubbles that central banks are unwilling to tackle. Moreover, savers aren't simply punished by near-zero returns; their nest eggs shrink further when the inflation rate outpaces deposit rates. And if improving consumer confidence is a prerequisite for a rebound in growth, then near-zero interest rates send the wrong message: They destroy nascent hope in the economic outlook and make the future that much more uncertain for consumers and companies.

Such arguments are gaining traction with a vocal minority of policymakers. In the U.K., Bank of England Monetary Policy Committee Member Andrew Sentance, who spent much of his career as the chief economist for British Airways (BAY:LN), has been alone in voting to raise rates at three consecutive meetings. And at the U.S. central bank, Kansas City Fed President Thomas Hoenig has dissented at all five policy meetings this year in a failed attempt to persuade his colleagues to drop their pledge to keep rates low for an "extended period." He argues that banks are now being paid for inaction, "earning a guaranteed return on free money from the Fed by lending it back to the government through securities purchases." Raising rates would encourage them to seek a return by taking on risk—and that would be stimulative.

Or so the argument goes. The hyperinflation that trashed Germany's economy in 1923, rather than the Great Depression that afflicted the U.S. later that decade, has set the tone for central banking in the modern age. The guardians of monetary stability are hardwired to favor higher rather than lower borrowing costs in anything other than emergency conditions. Provided the credit crisis is truly over, the natural response to the massive liquidity injections that have goosed the world economy is to crank up rates to keep inflation down.

Crisis Far from Over

The allure of contrary thinking aside, that would be a terrible mistake. The crisis is far from over. Risk has drifted from the banks to the governments that backstopped the financial industry. The problem is, there's no safety net underneath sovereigns. On Aug. 25 a Morgan Stanley (MS) research report warned investors that defaults on government bonds aren't out of the question. "Outright sovereign default in large advanced economies remains an extremely unlikely outcome," the report said. However, "Governments will impose a loss on some of their stakeholders."

The bond market is screaming a warning that deflation, defined as a sustained period of falling prices, is a much bigger threat than price increases. Ten-year government debt yields in the U.S. and Germany are in a race to see which can be first to drop through 2 percent; two-year Treasury yields are at a record low, below 0.5 percent, while Germany's 30-year borrowing costs are also the lowest ever seen. Wherever you look in the fixed-income market, inflation has been vanquished.

U.S. economic performance continues to disappoint. New-home sales collapsed by 12 percent in July to an annual pace of 276,000, the lowest level since the Commerce Dept. began compiling figures in 1964, and the median price of $204,000 is the cheapest since late 2003. Orders for durable goods rose just 0.3 percent, compared with the 3 percent gain predicted by economists. Against that backdrop, it's hard to see how anyone can get worried that higher rates are needed anytime soon to restrain inflation.

Those who oppose watering down the various stimulus packages that are keeping the economy alive see warning signs everywhere. Europe is looking anxiously to the East, concerned that China will be too successful at reining in growth. Olli Rehn, the European Union's economic chief, says that slowing Asian economies would have a "serious negative impact" on his region. The U.S., meantime, frets that Europe will slide back into recession, making the dreaded double-dip a reality. "Cutting back willy-nilly on high-return investments just to make the picture of the deficit look better is really foolish," Nobel prize-winning economist Joseph Stiglitz told Dublin-based RTE Radio in an interview broadcast on Aug. 24. And almost every supporter of doing more, not less, to resuscitate animal spirits is looking to the recent history of Japan as the chief reason why austerity should not be the new black. "What we're doing is setting ourselves up for a longer-term Japanese-style malaise of weak growth for an extended period of time," Stiglitz says.

Austerity Push in the U.K.

Even Axel Weber, typically a hawk among hawks at his Bundesbank roost in Frankfurt, says the European Central Bank should do nothing to slow the pace of liquidity keeping the economy afloat until at least the first quarter of next year. "The health of the financial system and the banking system" will dictate whether the recovery is sufficiently robust to withstand the withdrawal of central bank support, he said earlier this month.

It's the U.K. that is setting the pace on heading for the exit. Prime Minister David Cameron has embraced austerity and spending cuts in an effort to safeguard Britain's AAA credit rating and avoid the fate of Greece, whose surging deficit has made it a pariah in international capital markets. If Cameron can persuade Parliament to back his efforts to slash the U.K. debt burden, and succeeds in shrinking government payrolls without sabotaging the recovery, U.S. lawmakers keen to scale back government intervention might take heart.

Paul McCulley at Pimco, which runs the world's biggest bond fund, reckons it might take a stock-market slump to dissuade U.S. politicians from risking recession by embracing austerity. He's not forecasting collapse, though he thinks the risk is rising.

"Surreally, Congress is presently wrapped around the austerity axle," McCulley says. "I happen to think this is bad policy, very bad policy. That could change if the risk of a return to recession continues to rise, spooking the equity market. A few thousand points of Dow might be what is needed to get the attention of austerian legislators wanting to get reelected."

Gilbert is the London bureau chief and a columnist for Bloomberg News.

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