“Embrace change: it is the only constant in life” said a Greek philosopher some 2,500 years ago. This adage was confirmed in the early years of this century, where we saw significant changes that profoundly altered the world as we know it, how we behave as individuals, and how central banks and governments respond to adverse shocks. Three of these are the information and communication technology revolution, global warming, and the Global Financial Crisis. But what could these changes imply for policy responses that might take place in the next downturn? Could monetary policy and interest rates be replaced by fiscal policy and exchange rates?
The consequences of the changes
The Global Financial Crisis (GFC), and the unprecedented scale and scope of the monetary and fiscal policy responses, have changed our understanding of how economies work and what actions need to be taken to avert a downturn. Given that, after the GFC, the financial system did not collapse and the world economy avoided a second great depression, we can conclude that the responses were appropriate and effective.
To get the economies back on track, large-scale monetary and fiscal policies were needed. Now, years after the shock, economies are expanding at a modest to moderate pace, while still benefiting from accommodative monetary conditions. However, some of the central assumptions and beliefs about how economies work no longer hold water, suggesting that things have fundamentally changed. This is the new normal. For instance, the relation between the output gap and inflation, the so-called Philipps curve – the central assumption in monetary policy – has been called into question, as evidenced by the fact that, despite full-employment in the US, wages are only increasing modestly.
In this new normal, growth is modest and productivity is low, inflation and interest rates are low, central bank balance sheets are large, and public debt is elevated. In May, the U.S. economy entered its 106th month of expansion. This is the second longest expansion phase recorded since 1854 (the longest lasted 120 months). While business cycles do not die of old age alone, and this one could well beat the longevity records, we nevertheless think it is appropriate to envisage what the next recession policy responses will be.
In a Wall Street Journal article¹ from April, Eric Rosengren, the President of the Boston Fed raised a red flag. Essentially, his key conclusion was that a large portion of the fiscal capacity is already being used with the Trump stimulus and this reduces the government’s ability to lower taxes or boost federal spending to offset weakness. He also argues that, given the changes in the economy, the Fed is not likely to be able to raise rates as it did in the past. As a result, it will have less scope to lower them if needed. In an interview earlier this year, Larry Summers, a University Professor and former US Treasurer, said that in “the next few years a recession will come and we will in a sense have already shot the monetary and fiscal policy cannons, and that suggests the next recession might be more protracted”².
During a recession, the Fed used to cut interest rates by at least 5%. Currently sitting at 1.75%, and expected to be at less than 3% in the long term - according to the Fed dot plot, the Fed Fund Rate is set to remain too low to allow for the usual 5% cut. Forward guidance, quantitative easing and other unconventional tools will complement the small cut, but we don’t think it will be enough to sufficiently smooth the business cycle.
¹ "Fed’s Rosengren Worried Fiscal Stimulus Won’t Be There for Next Downturn"
The monetary policy response is likely to be supplemented by a fiscal policy response. Yet here again, governments’ policies are constrained. When interest rates are too high, governments cannot afford a debt-financed fiscal stimulus. This is exactly what happened to the Eurozone periphery only a few years ago and could well be the case again in the coming months if the Italian crisis further deepens.
The GFC shows what is likely to happen in the next downturn. A de facto collaboration between central banks and government policies emerged quickly after the Lehman moment, as it became clear that monetary policy remedies alone would not be sufficient to restore activity growth and stabilise the financial system. This was a pragmatic collaboration aimed at stopping the downturn. It was not designed to engineer an institutional rapprochement.
Ten years later, the relationship between central banks and governments has deepened and their destinies are now intertwined. In a low growth and low inflation environment, highly indebted governments need low interest rates to make government debt sustainable. At the same time, central banks need sustainable government debt, as government bonds are the “risk free” assets that the banking system is required to hold in order to comply with bank capital adequacy, balance sheet stress testing, and market liquidity risk (Basel III). As a result, debt sustainability is an important element of the stability of the banking system. In the next downturn, as central banks will not be able to reduce interest rates as in the past, they will need government fiscal stimulus to overcome their limitations. And in the next upturn, as government indebtedness will have increased again, central banks will need to keep interest rates at levels compatible with debt sustainability.
Collaboration has gradually morphed into mutualism, a relationship in which both institutions benefit from each other. The danger is that they cannot live without one another.
The most advanced example of mutualism is in Japan where the central bank explicitly guarantees that the government can issue bonds at 0% for up to 10 years. In the Eurozone and in the U.S., there is no official commitment to allow governments to raise debt for free. However, it would be nonsense for the ECB and the Fed not to keep an eye on the level of interest rates in relation to public debt sustainability. “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro” said Mario Draghi in the summer of 2012, the darkest hours of the euro-crisis. While the idea was also to return inflation to its target (its mandate), Mario Draghi first intended to avoid a government debt crisis and the Eurozone implosion. Now that Italy is making the headlines once more, the question investors have in mind is how high do Italian yields have to go before the ECB intervenes again.
How high can interest rates go?
The question we need to answer is how high interest rates can go without putting government debt at risk. We define debt sustainability as follows: debt is sustainable as long as the return of investment in dollars is greater than the cost of the debt (interest) paid in dollars. In other words, the return of a project must at least cover its costs. Governments have several goals, and therefore projects. Not all of them are economic, but we believe GDP is a good metric to measure the overall return on public investment. Government debt is generally measured as a percentage of GDP. High GDP means low unemployment and therefore political stability. It also means international power (bargaining and military power), as economic power is ranked according to GDP. Following this line of argument, a government’s return can be approximated with GDP growth and the costs are the interest rate payments on government debt. If the interest payments are larger than growth, the social return is not sufficient to cover the cost of financing, making it unsustainable.
The maximum sustainable interest rate a government can afford depends on growth, inflation, and its indebtedness. In our calculations based on OECD data, we assume that governments run a fiscal primary balance, meaning that they are neither expansive nor restrictive. This is a ‘heroic’ assumption, as history has taught us that primary deficit is the rule. According to our estimates, the maximum sustainable interest rates range from 4.8% - 6.1% for Germany, 3.3% - 4.0% for the US, 0.6% - 1.5% for Italy and 0.1% - 0.3% for Japan. We are using a range rather than a single estimate for each country, as we use both actual and potential growth in our calculation. Finally, to make these figures more meaningful, think about them as proxies for 10-year government yields.
In light of this, both upwards and downwards movements in interest rates are limited. For central banks, the lower limit is 0% broadly speaking and for governments the upper limit varies between 0% in Japan and up to 4% in the US. In the Eurozone, this figure is at best 1.5%, as the maximum sustainable risk-free rate is not defined by Germany but by Italy, which represents the key risk for the entire region. At the time of writing, 10-year Italian bonds yield is about 3.0%, a figure twice our best estimate of a maximum sustainable rate. This not only signals that Italy is under pressure, but that the Eurozone as a whole has entered a dangerous zone. It is, however, too early to conclude that a second euro crisis has started.
The type of monetary policy we experienced in the last decades is over. Central banks are no longer capable of smoothing the business cycle on their own. Fiscal policy is back in trend, but only insofar as interest rates allow.
Mutualism leads to symbiosis if every party plays according to the rules. If central banks are placed under the yoke of the State and, as a result, lose their independence, debt monetization and inflation is likely to follow as it did some decades ago. If, on the other hand, central banks continue to set interest rates according to their mandates, they will actually define fiscal policy.
The impact of controlled yield curves on exchange rates
Finally, if interest rates were controlled, they would no longer reflect economic fundamentals but arbitrate between monetary and fiscal policies. Japanese yields are fixed by the Bank of Japan (BoJ) at about 0% up to 10 years of maturity. By fixing interest rates at 0% in the first 10 years of maturity, the information content of the yield has been fully removed. It no longer reflects investors’ growth and inflation expectations but it allows Japan to run the largest fiscal deficit (5% of GDP) and to sustain the largest government debt (224% of GDP) of the developed world.
With controlled yield curves, investors would lose a precious compass and economies a key adjustment variable. For instance, the shape of the yield curve is well known to provide a reliable indication about whether or not a recession is approaching. In Japan, the BoJ sets the shape to be flat or, to put it simply, not to say anything about the future, as it is neither normal – signalling growth and/or inflation – nor inverted – signalling recession and/or deflation. Against this backdrop, the government yield curve can no longer meaningfully be used to value other asset classes or to adjust to different domestic economic conditions and riskiness in a currency union – to name but a few. Ignoring a reality does not make it less real. In this context, we believe that exchange rates will play an increasing role in expressing and adjusting for differences in economic fundamentals.
To continue with the Japanese example, the Japanese yen is one of, if not the most, undervalued currencies of the developed world. It illustrates that in a world where information is extracted from the yield curve there are massive currency adjustments. The high-risk premium associated with high government debt and large fiscal deficit, usually priced in the yield curve, is priced in the Japanese currency. According to fair value estimates, the yen is about 20% to 30% undervalued versus the U.S. dollar.
Whether or not John Maynard Keynes really said it is of little value, but the rhetorical question, “When events change, I change my mind. What do you do, Sir?” remains relevant today. The world has changed a lot in the last 15 years and the policy responses to come will be adapted to the new situation. In the current economic environment of modest growth, low productivity, low inflation and interest rates, large central bank balance sheets and high public debt, a tight collaboration between fiscal and monetary policy has emerged. We call this collaboration mutualism.
Mutualism relies heavily on the control of yield curves with, as a direct result, the loss of a precious compass for investors and a key adjustment variable for economies. Ignoring a reality does not make it less real. In this context, we believe that exchange rates will play an increasing role in expressing and adjusting for differences in economic fundamentals.