On January 29, 2016, Bank of Japan Governor, Haruhiko Kuroda, hosted a press conference about Japan’s decision to lower interest rates below 0% for the first time, making the following comment:
The constraint of the ‘zero lower bound’ on a nominal interest rate, which was believed to be impossible to conquer, has been almost overcome by the wisdom and practice of central banks, including those of the Bank of Japan.
He followed this up with a praiseworthy statement for his fellow central bankers:
It is no exaggeration that [ours] is the most powerful monetary policy framework in the history of modern central banking.
But in the U.S., Bill Gross, former PIMCO boss, took a polar opposite stance in his February 2016 outlook, titled “Increasingly Addled.” In it, he took issue with central bankers and their convictions that ever lower rates will be good for the global economy:
They all seem to believe that there is an interest rate SO LOW that resultant financial market wealth will ultimately spill over into the real economy. I have long argued against that logic and won’t reiterate the negative aspects of low yields and financial repression in this Outlook. What I will commonsensically ask is ‘How successful have they been so far?’
While Governor Kuroda deems the policies exerted by today’s central bankers as necessary and commendable, Bill Gross sees them as impotent, or worse, potentially dangerous. It is like two people staring at an abstract painting. One views it as legitimate art, while the other snorts that it’s the kind of messy scribbles his three year old makes at home.
So who is “right?”
In addressing this question, it makes sense to consider why these policies are being pursued in the first place.
The overarching rationale for the loose monetary policy that we see across a number of advanced economies is to stimulate growth and achieve target levels of inflation (~2% for most major advanced economies). Central banks are hoping to encourage consumers and businesses to borrow and spend more by driving down the level of interest rates. In simple terms, cheap credit = more investment = more jobs = more growth = more inflation. They are pulling on the credit lever in the economy.
In lowering rates, central banks are also putting downward pressure on their currencies, which can also help to stimulate growth. Of course, central bankers are quick today to say this isn’t specifically their intention as they don’t want to spark a currency war. However, if their currencies fall as a byproduct, we doubt they mind very much.
Central banks are relying on strategies that have traditionally worked well to boost growth during recessions. The problem is that we aren’t seeing the desired outcomes. And in the two places these policies are being pursued the most aggressively–Japan and Europe–growth remains anemic and inflation elusive. The only outcome we can point to with some conviction is that the prices of financial assets have soared. But their policies aren’t seemingly translating to the “real economy.”
So what is going on? Is it simply a matter of time and even more stimulus before we see the desired results? Are we just missing the signs that their efforts are indeed working? Or are the critics—like Gross—right, and the credit lever is broken and this is all for naught?
A Broken Credit Lever
One indicator that the credit lever may be broken is the long term debt cycle. As Bridgewater founder Ray Dalio explains in the Financial Times article, Pay attention to long-term debt cycle, the effectiveness of central bank policies depends not only on the business cycle but also on where we are in our total accumulation of debt as a society:
We are seven years into the expansion phase of the business/short-term debt cycle – which typically lasts about eight to ten years – and near the end of the expansion phase of a long-term debt cycle, which typically lasts about 50 to 75 years.
It is because of the long-term debt cycle dynamics that we are seeing global weakness and deflationary pressures that warrant global easing rather than tightening.
Normally, lowering the interest rates in an economy encourages businesses and individuals to spend and invest. But what happens if we have accumulated a lot of debt over the years? What if our industries are already in overcapacity/overbuilt? What if people already have enough stuff? Then, even though credit is cheap, no one really needs (or has the means) to spend more.
Dalio puts it succinctly:
What I am contending is that there are limits to spending growth financed by a combination of debt and money. When these limits are reached, it marks the end of the upwards phase of the long-term debt cycle. In 1935, this scenario was dubbed “pushing on a string.”
If this is what’s going on, then it won’t matter how much additional firepower central banks throw at the economy: they are shooting blanks. Central bankers may have to wait until the system clears itself.
Probably Not a Masterpiece
Like so many problems in life, the answer to who is “right” about these policies is not clear, and we can’t predict how all of this will unfold. But that doesn’t mean that we can’t lean in one direction or another. And our team is generally skeptical that the actions taken by the BOJ and the ECB are masterpieces.
At a minimum, it seems unreasonable to be celebrating current policies. While low interest rates may be the only tenable policy option for Japan and Europe right now—because to raise interest rates with no inflation in sight makes little sense—the logic of applying additional stimulus seems questionable. When a person is hurt it is reasonable for the doctor to put the patient on morphine to get them through the most painful moments of healing. But after the initial healing has occurred, injecting further morphine is not going to help in the recovery process—and it risks turning the patient into an addict. Negative interest rates, quantitative easing… these experiments have a low chance of driving desired outcomes if the credit lever in these economies is temporarily broken.
For the investor, the main takeaway is the necessity of having a portfolio that can be resilient to whatever unfolds from here (yes, we sound like a broken record). Maybe central bankers have it right and growth and inflation do return. Or maybe, these policies amount only to “pushing on a string” and end up only supporting asset prices. Either way, your portfolio needs to be positioned to put the odds in your favour.
In our view, loose monetary policy eventually breeds capital misallocation. The longer it goes on, the more likely investors and companies misallocate. Already, we have signs of this happening: companies appear more willing to pay up for acquisition targets, many companies are increasing their total leverage, and investors seem willing to accept poorer credit standards on corporate bonds (i.e., covenants are getting weaker). These are not positive trends.
For these reasons we find it especially difficult to be jubilant about current policies. The consequences of a prolonged loose interest rate environment are almost never palatable.
For now the central banks exhibit remains open for observation and critique. Time will tell whether lower interest rates will be deemed museum worthy or simply paint by numbers.