Fear of “Reversal Rates” Sets in, Says the Fed

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by Wolf Richter, Wolf Street:

The fear that today’s negative or low interest rates render central banks helpless in face of the next economic crisis.

This is the transcript from my podcast last SundayTHE WOLF STREET REPORT:

There is now a new theory cropping up in Fed-speak and more generally in central-bank speak. It’s not actually a new theory. I have been saying the same thing for years. In fact, it’s not even a theory, but reality. But it’s newly cropping up in reports from the Fed and the ECB. It’s the concept of what is now called “reversal rates.”

It’s an official admission that “reversal rates” exist. The term crops up alongside the fear that countries with negative interest rates are at, or are already beyond, those “reversal rates.”

The idea of interest rate repression is to induce businesses to borrow and invest, and to induce consumers to borrow and spend, and the hope is that all this will crank up the overall economy as measured by GDP.

“Reversal rates” is the term for a situation where interest rates are so low that they’re doing more harm than good to the overall economy, and that lowering rates further will screw up the economy rather than boost it.

Central bank monetary policy, such as cutting interest rates and doing QE, takes wealth and income from one group of people and delivers it to another group of people. This is how monetary policy works. It’s not a secret. In central-bank speak, it’s called the “distributive effects of monetary policy.” The idea is that for the overall economy, this income and wealth transfer from these people over here to those people over there translates into more overall economic activity that adds to GDP.

The problem for central banks arises when too many people and businesses get screwed by these policies and when they alter decision-making in absurd ways – which is what low and negative interest rates do – to where the overall economy actually takes a hit when rates drop further.

This issue of “reversal rates” has cropped up for the first time in the Fed’s Financial Stability Report that it released a couple of days ago.

So now reversal rates are a thing. Suddenly, they’re seen as the second highest risk to the economy, after trade frictions, in the eyes of big economic players that the Fed cited in the report.

In its Financial Stability Report, the Fed says that the risks from, quote, “advanced-economy monetary policy are front and center.”

This “advanced-economy monetary policy” means ultra-low or negative interest rates and QE in effect in the advanced economies.

Given that these policies are still in place after many years, and given that the Fed has just cut rates three times, despite there not being any economic need to do so, there are now fears that the Fed and other central banks would be helpless in countering the next economic crisis.

And I quote from the Fed’s Financial Stability Report:

Many respondents wondered whether central banks would be able to counter an economic slowdown due to already low levels of interest rates and compressed risk premiums.

“Relatedly, some contacts argued that select foreign central banks with negative policy rates were either close to or beyond reversal rates, which are the rates at which the negative effects of incremental easing – for example, weaker profitability of financial institutions or higher precautionary savings from retirees – might offset positive growth impulses.

And the report went on:

With regard to the Federal Reserve specifically, a few contacts highlighted the possibility that U.S. interest rates could turn negative, with potentially severe repercussions for money market funds and the municipal bond market.”

We’ve already seen that negative interest rates are terrible for banks. They destroy the core business model for banks and make future bank collapses more likely because banks cannot build capital to absorb losses.

Banks are a crucial factor in a modern economy. And they’re getting hammered in countries with very low or negative interest rates. Japanese bank stocks are down 90% from the peak 30 years ago, and European bank stocks are down 70% from 12 years ago and are now back where they’d first been in the mid-1990s.

If interest rates go very low or negative, the spread between a bank’s cost of capital and the interest rate it can charge on loans in order to make a profit gets thinner.

Read More @ WolfStreet.com

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