Nov. 7, 2016

Stephen Jarislowsky: Central Banks and Interest Rates

We are living in a period of unprecedented low interest rates.  There are even countries where you pay interest on your own bank balances, such as Japan and some countries in the eurozone.  Compare this with 18% interest rates in 1981, when inflation was rampant after the OPEC formation caused crude oil prices to balloon.  At that time wage inflation in North America competed with the rise in interest rates, as neither central banks (Canada & USA), nor politicians could or wanted to arrest the catastrophic loss in the real value of North American currencies.

Today we have no wage inflation in North America except in some isolated pockets.  Rather, real wages are on a down curve as, due to globalization, low foreign wages – largely Asian − lead to all labour costs becoming increasingly, although very gradually, one commodity.  As such, our high real wages will, over time, increasingly diminish in real value, while hopefully those in Asia and elsewhere, where they are now low, should begin to slowly rise.  Lower labour compensation in North America means lower purchasing power and, until balanced with those in Asia, will result in a reduction in the standard of living.

Politicians do not win elections preaching belt-tightening, and central banks, while de jure independent of government or political influence, are expected to maintain around 2% inflation, maintain employment and so on through “monetary policy”.

Well, with world trade comes world competition, and so in order to remain competitive, one has to keep costs as low as possible. As interest is a cost for manufacturers and other employers, reducing interest rates is a reduction of cost.  So interest rates were slashed.  Moreover, in recessionary periods, government deficits usually increase, leading to new bond sales.  The lower the interest, the lower the cost for government.  At 1.3% interest in Canada and 1.5% inflation, the government pays no interest in real terms − and actually earns 0.2%.  If consumption is to be maintained, keeping a low interest rate reduces borrowing costs, lessening the burden for consumers with stagnant real income.  Low interest rates also inevitably lead to increased consumer debt levels as it allows them to carry more debt.

If this manipulation to lower rates benefits borrowers, on the flip side, it unfairly punishes the savers, acting like a tax on their savings. The result is ever-increasing debt levels which will ensure that the next recession is deeper and the subsequent recovery less robust. As the population ages and life expectancy increases, the ratio of older retired people to those in the workforce also increases. This will result in a material long-term income deficiency, thus reducing the standard of living of those retired as well as the working population, which must now shoulder increasingly higher costs for retirees. Low interest rates also lead to higher prices for housing and other large consumer purchases as it permits people to borrow more. 

On the same side of the ledger, low interest rates make dividends more valuable, especially rising dividends as the spread between the stock yield and interest rate has widened.  This leads to higher share prices.  Also companies that borrow funds to operate have lower interest costs, accelerating potential profits.

Today’s low interest rates are unprecedented, having fallen year after year since 2008 —when the world’s global financial system almost crashed.

Aside from these fabricated rates, the central banks also printed money and used it to buy bonds and mortgages to manipulate the interest rates lower, as their massive buying at even lower prices demolished normal supply and demand.  It was a worldwide race for the bottom to keep consumer spending up while also making domestic cost lower to compete with exports.

Now, here are the reasons why I happen to believe that the central banks have been mistaken:

• Low rates distort rational markets.Investors are entitled in a free country to have free markets, not “rigged” ones.Risk should be fairly rewarded.
• Low interest rates are a destruction of wealth creation, if more than strictly temporary, especially for older people who will need to cut their spending or buy higher-yielding assets, which come with higher risk that they should likely not be taking.The seven years since the 2009 collapse indicates that the low rates are more than temporary.
• Low interest rates only delay the eventual adjustment of reducing debt and boosting savings. Until then, however, the consumer may become even more indebted. Once interest rates rise to normal levels, there is the serious threat of bankruptcy and a reduction to a lower standard of living, especially for older people.They also lead to excessive government debt, and eventually reduced social and other spending.
• Low interest rates lead to a lack of discipline on the part of consumers, corporations and government.A consequence is central bank “money printing”. This may also entail higher corporate systemic risk, and possible corporate bankruptcies when rates normalize.They also prevent a gradual adjustment to economic reality by retaining an unsustainable standard of living well beyond what is reasonable. The resulting required adjustment may be catastrophic.
• Low rates postpone a return to growth and prosperity as it delays balance sheet repair that would lead to new productive investment and so to an upswing of the economy.Over-indebted consumers make such a renewal near impossible.
• Low interest rates have done little to stimulate trade as most nations around the world have followed suit with rate cuts of their own. What does result, however, is the long-term damage to all economies without any accrued advantage.

Already, the hesitation by the Federal Reserve Bank, month after month, to correct the injustice, even in a minor way, illustrates the inevitable path to negative consequences, made worse by the longer this distortion persists. There is no reason to doubt, since the medicine has not cured the patient —though even more was prescribed — that it is doomed to failure.

If central banks are truly independent of politics, I suggest that the central bank chiefs agree to gradually, and in tandem, raise rates, so as to not allow any country to “beggar thy neighbor.” In doing so, we would avoid any sudden shocks to the world economy and mitigate bankruptcies and the consequent suffering.

Stephen Jarislowsky

October 2016