The State of the Nation: Say hello to extended low interest rates

This article first appeared in The Edge Malaysia Weekly, on August 12, 2019 - August 18, 2019.

The Fed cut interest rates by 25 bps last month after having raised rates three successive times since last December. Photo by Reuters

Source by IMF

Source by World Bank

Source by Bloomberg

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THE widely expected 25 basis points (bps) rate cut by the US Federal Reserve last month pretty much confirmed that low interest rates are here to stay. The cut in the benchmark federal funds rate to a range of 2% to 2.25% is the first since December 2008.

While many were predicting that the cut would be higher at 50 bps, it comes after three successive raises in interest rates since last December.

Central banks around the world are also cutting interest rates, with Bank Negara Malaysia reducing its overnight policy rate in May. More recently, shortly after the Fed announced its rate cut, the Reserve Bank of New Zealand shocked many by slashing its official cash rate by 50 bps to 1%.

The rate cuts by central banks around the globe in recent times are a response to fears of a more pronounced global slowdown, says United Overseas Bank (M) Bhd senior economist Julia Goh.

Lee Heng Guie, executive director of the Socio-Economic Research Centre (SERC), concurs.

“With the heightening global economic uncertainties due to the elevated trade tensions, we expect global interest rates to stay low — at least over the next 12 months — to provide insurance against any unattended risks that would undermine the global economy,” he tells The Edge.

“The concern is that a severe enough shock could usher in a sharp economic slowdown or even a recession risk in the US economy,” says Lee.

Goh says nevertheless, even in the absence of any severe shock, interest rates are expected to stay lower for longer partly due to structural shifts — such as low inflation, slower productivity and an older population — that are affecting mostly advanced economies.

It would be fair to say that the global economy is “addicted” to low interest rates that have been in place for over a decade. That is because it has helped lower the cost of funds, making borrowing cheap, which is meant to stimulate demand and lower the hurdles for investments.

It has helped economies around the world recover from the global financial crisis of 2008/09 and help put the US in its longest period of economic growth.

“Some emerging countries have monetary space to lower interest rates, but it might not be necessary for them to use it. There are other macro policy tools available besides monetary policy like fiscal policy or industrial and trade policy. The decision should be made on which tool is the most effective in driving growth,” says Sunway University Business School economics professor Dr Yeah Kim Leng.

However, he warns that lower interest rates over the medium to long term will have its consequences of potential financial imbalance or unproductive investments.

SERC’s Lee says investors in both financial markets and households are addicted to low interest rates to spur debt-fuelled consumption and excessive risk investments.

He adds that the state of the global economy that is fragile places immense pressure on central banks to use their monetary arsenal, given the fiscal constraints and high debt situation of some governments.

“Unfortunately, this time round, monetary policy tools are limited. Interest rates are very low and it gives the central banks very limited room to cut interest rates.

“Today, the Fed is starting with a benchmark policy rate of 2.25% to 2.5%, compared with 5.25% in September 2007. In Europe and Japan, central banks are already in negative-rate territory and will face limits on how much further below the zero-bound they can go,” says Lee.

 

Woes of prolonged low interest rates

There is no denying that expansionary monetary policy alongside fiscal stimulus has helped to spur economic revival post-global financial crisis, but experts say it has also created financial imbalances in the form of excessive leveraging by corporates, households and governments.

As at end-December last year, global debt stood at 233.7% of world gross domestic product, which exceeded the previous record of 213% in 2009.

“Since the global financial crisis, the global recovery has been largely driven by monetary and fiscal stimulus but lacks fundamental and sustainable growth drivers through the undertaking of structural reforms to increase productivity, increase quality and productive investment such as infrastructure, education and technology advancement, and human capital formation,” says Lee.

He adds that the biggest concern with the prolonged low interest rate environment is financial stability as investors, households and financial firms respond to “low-for-long” interest rates by increasing risk-taking activities and undertaking speculative investment without being supported by fundamentals.

“The debt binge and over-leveraging will expose the corporates, households and financial sector to vulnerabilities if there is a severe economic downturn, leading to loss of employment and income, as well as a reversal of low interest rates.

“The issue of financial stability is also closely related to a low interest rate environment, which could result in elevated valuations, asset price bubbles, higher risk-taking and a search for yield. This requires putting a strong macro-prudential framework in place,” says Lee.

The low interest rate environment has also driven up asset prices and this could continue.

“Key drivers of asset prices are easy access to funds and low cost of funds. The concern is a sharp market correction and the negative effects that it will cause and spill over into the economy,” says Sunway University’s Yeah.

While interest rates are set to remain low for an extended period of time, whether we can get out of this situation remains to be seen.

“Looking at post-global financial crisis, the Fed only started to normalise its benchmark interest rate in baby steps by a cumulative 250 bps from 2015 to 2018, before cutting rates last month and stopping the unwinding of its balance sheet to safeguard the US economy against the implications of protracted trade tensions. Bank of Japan and the European Central Bank still cannot get out of the negative interest rate environment till today,” says Lee.

 

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