Are low interest rates a time bomb?

The Centre for Economic Policy Research (CEPR) recently organised a conference at the Brewers’ Hall, London, on 10 June 2013 titled ‘A long-term environment of low nominal interest rates: what are the consequences for the financial sector’?

The workshop marked the launch of CEPR’s new research initiative on financial regulation. It brought together academics, policymakers and practitioners to discuss existing theory and empirical evidence on the implications of an extended phase of unconventional monetary policy, i.e., monetary policy operating at the ‘zero lower bound’; as well as the emerging trends in investment strategies of financial intermediaries as a response to such monetary policy.

Many central banks have recently employed unprecedented expansionary monetary policy, keeping interest rates at near-zero levels for an extended period of time since the crisis of 2007-08. Quantitative easing interventions have been employed to affect asset prices directly, most notably in government-bond and mortgage markets, in order to keep sovereign and mortgage borrowing costs low. These interventions may have the beneficial aspect of generating wealth transfers to borrowers, notably banks and households with negative home equities. But they may also be stoking asset-price inflation, often in unexpected fashion, by inducing a ‘search for yield’ among savers and intermediaries who manage their savings. These intermediaries include not just banks, but also money-market funds, pension funds, insurance companies, hedge funds, real-estate investment trusts, among others, which together comprise ‘shadow banking’. This is an important part of the financial sector that is not regulated as banks but performs similar economic functions and is often inter-connected with banks.

Discussion

Presentations during the workshop focused on how the recent financial crisis had challenged perceptions of the relationship between interest rates and risk taking. The weight of evidence confirms that low interest rates do indeed lead to greater risk taking and unintended responses from both the financial and the non-financial sector, but the magnitudes of these effects are both little understood and hard to measure.

A second major topic of discussion was whether and how the regulatory toolkit of macroprudential policies, currently aimed at banks, should expand its perimeter to shadow banking. This might contain the emerging sources of financial fragility, as – and possibly even before – the central banks begin to exit from the expansionary monetary policies and asset prices experience interest-rate corrections. While there has already been a significant focus on the need for more effective macroprudential policies since the onset of the crises in 2007-08, there remains a significant lack of clarity over the effectiveness of these policies and, indeed, the interaction of these policies with monetary and microeconomic policies.

A third area of focus was the key role played by the financial system in maturity transformation. Banks are looking forward to the exit of central banks’ low nominal rate policies given their reduced intermediation margins. Moreover, low interest rates in a world of continually tight bank regulation cause capital flows into non-bank channels of intermediation. This raises further issues about the efficiency and transparency of these flows, as well as the perimeter of regulation. Some conference participants noted that shadow financial intermediation may not necessarily be detrimental and may even be considered beneficial because of the benefits of diversification and reduced dependence on bank intermediation. Others were concerned, however, that regulators may be taken by surprise when it is the shadow banking sector, rather than banks, that experience significant adverse effects from exit of unconventional monetary policy.

A consistent theme of the conference was the degree to which the low interest-rate environment would lead to restructuring in the financial sector – migration of risks to the shadow banking sector – and what kind of restructuring this could or should be. In addition, questions arose regarding the relationship between the financial sector and the non-financial sector. Recent studies suggest, for example, that the persistence of low interest rates in Japan and the prolongation of emergency interventions may have contributed to a lack of fundamental restructuring of small and medium-sized enterprises. One reason limiting the effects of unconventional monetary policy on real-sector growth and jobs is that the relative value transfer to borrowers from low interest-rate policy meant that corporations could generate shareholder value simply by ‘financial arbitrage’ of issuing bonds and repurchasing shares, rather than engaging in true economic value creation.

Discussion turned to the task facing central banks in communicating their exit strategies. Formulating and executing exit strategies is more art than science, and central banks are currently ‘feeling their way’. In one sense, a part of the success of this period of extraordinary monetary-policy measures would be the extent to which the time bought by these policies would be used to achieve the necessary structural reforms at both the sovereign and institutional levels. Participants expressed considerable scepticism that the necessary structural reforms would in fact be undertaken.

Conclusions

A return to a more ‘normal level’ of interest rates and yield curve will produce winners and losers. Some banks, particularly those that are better capitalised, will probably benefit from a normalisation in rates. Less well-capitalised institutions could well suffer. This highlighted the need to consider the interaction of monetary policy with other macroprudential and microeconomic policies.

One solution to the low-growth, low-interest environment might be for central banks to target higher inflation more deliberately and aggressively (e.g. Japan). But such a stance would require a huge step up in extraordinary monetary-policy measures, and this in itself could prove destabilising. There was also scepticism that central banks know exactly how to generate such higher inflation, their expansionary policies since 2007-08 having failed to do so.

It is clear that there has been a noticeable flow of capital into relatively fresh areas of the financial system. This both increases the risks of ‘bubbles’, or pockets of asset-price inflation, and creates the risk of disruption if and when these flows are reversed. Also untested is the risk appetite for these new flows. This fuels a broader debate around the potential misallocation of resources and what, if any, role the public sector should have in this area.

Somewhat coincidentally, the recent indication of a possible slow-down or unwinding by the Federal Reserve of its unconventional monetary policy has induced a bout of market corrections and volatility. Many observers have attributed this to stoking of asset-price inflation in the period before this indication. The financial sector may now be seeking an exit from its own search-for-yield strategies while the central banks are possibly seeking an exit from their own unconventional policies.

This article first appeared in voxeu.org

Editor’s note: This column is the second in a new series of “Vox Views“, which are short video interviews with world-renowned economists.

Authors: Viral Acharya, Professor of Finance, Stern School of Business, New York University and Director of the CEPR Financial Economics Programme. Richard Portes, Professor of Economics at London Business School and President of CEPR. Richard Reid, Honorary Research Fellow, University of Dundee; Research Associate, CEPR.

Image: An office worker walks in front of a board showing the exchange rate for the Australian dollar REUTERS/Daniel Munoz