How can the UK adjust to a world of lower interest-rates and yields?

One of the features of the credit crunch era has been the fall and if you like plunge in both interest-rates and bond yields. This first started as central banks cut official interest-rates sharply as the crisis hit. When that did not seem to be working ( the modern word covering that is counterfactual) they then moved to policies such as Quantitative Easing to reduce longer-term interest-rates and yields. Next came more interest-rate cuts and the advent of Qualitative Easing which for a while was called credit easing in the UK. This now comes under the banner of the Term Funding Scheme in the UK, or actual support for loans at the Bank of Japan or the TLTROs and securities purchases by the ECB ( European Central Bank).

So we saw official rates fall and then central banks realised the consequence of controlling rates which run from overnight to one month money. This is that there are plenty of other interest-rates such as bond yields and mortgage rates so our control freaks moved to lower them as well. After all their Ivory Tower economic models predicted economic triumph if they did. To ram all this home some places also went into negative territory for interest-rates from which no-one has yet returned with Denmark briefly giving it a go before preferring another ice bath. For the UK we were reassured that we were at the bottom of the cycle as Bank of England Carney told us that a Bank Rate of 0.5% was the lower bound. Of course he later cut to 0.25% and then told us that the lower bound was near to but just above 0%. This of course was silly on two fronts. Most obviously it ignored the fact that much of Europe and of course Japan already have negative interest-rates and it also led to the really silly expectation of a cut to 0.1%.

The rise of the zombies

It was only a few days ago that I pointed out that in my opinion the rise of zombie companies and businesses was strangling productivity growth. That reminded me of my description of Unicredit in Italy as a zombie bank around 5 years ago and of course it still is. But in the meantime thank you to @LadyFOHF for pointing out this from FT Alphaville.

It quotes the Bank for International Settlements or BIS on this subject.

One potential factor behind this decline is a persistent misallocation of capital and labour, as reflected by the growing share of unprofitable firms. Indeed, the share of zombie firms – whose interest expenses exceed earnings before interest and taxes – has increased significantly despite unusually low levels of interest rates (right-hand panel).

That bit could not have been written by me clearly as if it had “despite” would have been replaced by “because of”. This bit might have though.

Weaker investment in recent years has coincided with a slowdown in productivity growth. Since 2007, productivity growth has slowed in both advanced economies and EMEs

There are dangers in assuming that correlation does prove causation but look at the right zombie company chart. Just as growth was fading the central banks gave it another push and rather than the reforms we keep being promised we in fact got “more, more, more”. More worryingly the line continues to head upwards.

In case you are wondering here is their definition of a zombie company.

The BIS dubs a zombie company any firm which is more than 10 years old, listed and has a ratio of EBIT to interest expenses below one.

If you are wondering ( like me) that others could be on the list then so was Izzy at the FT.

This means Uber, which is now eight years old, only has two years and a public listing ahead of it, before it too can be classified a zombie.

That I find fascinating as Uber and similar companies are a modern era triumph supposedly.In my part of London I regularly pass people holding up their mobile phone as they track down their Uber taxi. To be fair it has usually arrived in the time it takes me to walk past and in fact if it takes longer than that some seem to get upset. So here we really have a quandary which is a zombie which is apparently extremely efficient!

The FT poses an issue here.

why does profitability not matter anymore? And where does the extended patience with unprofitable companies lead us in the long run? Surely, nowhere good?

I will go further as on this road we see strong hints as to why productivity growth has been so low ( in fact more or less zero in the UK) which will hold back wage and real wage growth. All of them together mean that economic growth will be restricted as we are reminded of 2% being the new normal on any sustained basis. If we throw in the official under measurement of inflation we then find we have little if any economic growth at all. Is that enough as a consequence of low interest-rates where the “cure” has in fact become part of the disease? Perhaps Tina Arena was right.

I pretend I can always leave
Free to go whenever I please
But then the sound of my desperate calls
Echo off these dungeon walls
I’ve crossed the line from mad to sane
A thousand times and back again
I love you baby, I’m in chains
I’m in chains
I’m in chains
I’m in chains

The banks

The official story is that low interest-rates are bad for the banks. But if this from @grodeau about Swedish banks is true in the UK which I believe to be so we may have been sold a pup.

In terms of margin they are doing better than before the credit crunch as we find we are feeding a whole field of zombies like this is some form of new Hammer House of Horror series. Or to answer the question posed by Obruni in the FT. Yes.

The ROEs of most major banks have been below their costs of capital since 2008. Are these zombies too?

The UK should not issue more index-linked Gilts

There are suggestions that we should do this and as ever I will avoid the politics and just look at the economics and finance. I spotted this yesterday from Jonathan Portes.

Failing to borrow long-term at negative real rates to fix roofs (& other things) over last 7 years an act of deliberate economic self-harm

This reminds me of the online debate he and I had a few years back. The issue he  is apparently glossing over can be summed up in the use of the word “real”. In a theoretical Ivory Tower world it is clear but beneath the clouds where the rest of us live it has changed a lot in modern times. Let me summarise some issues.

  1. Imagine inflation were to stay at around 4% ( these are based on RPI inflation) for a while. Our negative real rate would in fact be very expensive as we paid it.
  2. We do not know what we will pay as our commitment is in fact open-ended depending on inflation. As it is so I am dubious about negative real rate calculations.
  3. If we switch to wages growth we see that something has changed. If that persists then the real rate versus wages may turn out to be very different.

If I was borrowing I would borrow in terms of conventional Gilts where the 30 year cost at 1.9% is extraordinarily cheap and a known cost as in we know what we will be paying from the beginning. Putting it another way index-linked Gilts are tactically cheap but I fear they will be strategically expensive.

Comment

As we look at the new economic world we see that some are trying to escape but that progress for them has been slow. After all the US has merely nudged its rates to a bit above 1% and Canada has only moved to 0.75% this week. So it seems that we will have to get used to low interest-rates for a while yet as we note that they have come with lower productivity, wage growth and economic growth. Not quite what we were promised is it?

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The trend towards ever lower interest-rates continues but what about bond yields?

A clear feature of the credit crunch world has been lower interest-rates and lower bond yields. This has come in two phases where the first was badged usually as an emergency response to the credit crunches initial impact. However as I warned back then central banks had no real exit plan from such measures and we then found that the emergency had apparently got worse as so many central banks cuts again. So if you like we went from ZIRP ( Zero Interest-Rate Policy) to NIRP ( N is Negative) . Along the way it is easy to forget now that the ECB did in fact raise interest-rates twice but the Euro area crisis saw it cut them to -0.4% and to deployed over a trillion Euros of QE bond buying so far. In the UK Bank of England Governor Mark Carney also retreated with his tail between his legs after a couple of years or so of Forward Guidance about higher interest-rates which turned out to be anything but as he later cut them to 0.25%!

Reserve Bank of New Zealand

Yesterday evening the Kiwis again joined the party.

The Reserve Bank today reduced the Official Cash Rate (OCR) by 25 basis points to 1.75 percent.

I have a theory that the RBNZ regularly cuts interest-rates when the All Blacks lose at rugby union and on that subject congratulations to Ireland on finally breaking their duck. Moving back to interest-rates that makes 40 central banks ( h/t @moved_average ) who have eased policy in 2016 so far which poses a question over 8 years into the credit crunch don’t you think? Central banks used to raise interest-rates when they claimed a recovery was developing.

Also we can learn a fair bit about the modern central bank from looking at the explanatory statement from the RBNZ.

Significant surplus capacity exists across the global economy despite improved economic indicators in some countries.

Perhaps only the Governor can tell us whether that psychobabble is good or bad! Anyway central banks used to cut interest-rates if the economy is either weak now or expected to be so let’s take a look.

GDP grew by 3.6 percent in the year to the June 2016 quarter, and near-term indicators suggest this pace of growth is likely to continue. Annual GDP growth is forecast to average around 3.8 percent over the next year. This strength has been a feature of the Bank’s projections for some time……….. As GDP is forecast to grow at a faster rate than the economy’s productive capacity, the output gap is projected to rise, contributing to inflationary pressure.

Oh well perhaps not. Also there is another (space) oddity if we look at a cut in interest-rates.

The combination of high population growth, low mortgage rates, and a shortage of housing in Auckland has continued to exert upward pressure on house prices…….Outside of Auckland and Canterbury, house price inflation reached a 10-year high in July, but has fallen slightly since.

Ah yes so a cut in interest-rates will help? Oh hang on as we observe this.

Mortgage rates remain around record lows

If we look at the chart we see that it is no surprise that house price inflation has slowed in Auckland because it want over 25% per annum. For some reason ( perhaps someone familiar with NZ can explain) Canterbury saw over 25% around 3 years ago. However the rest of New Zealand has seen a rise to around 10% per annum. Many would call this quite a boom and a central bank would raise interest-rates. Of course these days we are promised policies from long enough in the past that most will have forgotten they were failures back then.

This follows the announcement of further tightening of loan-to-value ratio restrictions in July 2016.

Also with the New Zealand economy growing so strongly it is hard ot avoid the feeling of beggar thy neighbour about this.

A decline in the exchange rate is needed.

The inflation argument is not so strong even for those who believe that 2% is better than 0%. Added to house prices we see this.

Annual inflation is expected to rise from the December quarter,

One area that is awkward for the central bank is this.

 On an annual basis, the net inflow of working-age migrants rose to a new peak of around 60,000 in September

Of course establishment s everywhere tell us how fantastic this will be for economic growth which makes the rate cut even odder. But we see that it will have ch-ch-changes on New Zealand that elsewhere have contributed to not quite the nirvana promised. It is hard as a Londoner not to have a wry smile at this because both socially and in business you meet so many Kiwis some who are here for a while and some end up staying. It is however of course an urban myth that they all live in one camper van in Kensington! But if the mainstream media finally gets something right in 2016 New Zealand may be about to see a flow of American immigration as well.

The RBNZ does not give us GDP per head which would be interesting to see. We do however get something that as far as I know is unique in the central banking world.

We assume that over the medium term the price of whole milk powder will tend towards USD 3,000 per tonne, and that the Dubai oil price will continue to gradually increase to around USD 60 per barrel.

Firstly you get the wholesale milk price as you note it is provided before the crude oil price!

A Challenge to the central bankers

The RBNZ kindly gave us the central bankers view of what happens next.

Policy rates are at record lows across
most advanced economies and are expected to remain stimulatory over coming years. In 2016, quantitative easing by central banks has been at its highest level since the global financial crisis. The degree of unconventional monetary policy is unlikely to increase further.

Of course Forward Guidance from central bankers has been anything but that! Also whilst they may well continue to reduce official interest-rates it looks to me as if there will be trouble elsewhere. This is because inflation looks set to rise and its impact on real or inflation adjusted bond yields. There was an element of this in the rise in the US 30 year bond yield that I pointed out yesterday after Donald Trump was elected.

Putting it another way the chart of inflation expectations below is revealing. However take care as these things are very broad brush as in useful for trends but very inaccurate in my opinion.

That starts to make current bond yields look a bit thin doesn’t it?

Comment

Today I have been looking at two opposite forces as the central banking army continues its advance but faces more potential guerilla style opposition. We do not yet know how much inflation will pick-up overall but we do know that unless the oil price falls heavily it will do so. We also know that in some areas we are seeing hints of commodity prices rising again as for example Dr.Copper has been on the move. in response bond yields are rising today and as summer has moved into autumn we have been seeing this overall. For example the ten-year bund yield in Germany is now 0.28% as I type this. This is simultaneously giddy heights compared to recently as well as still very low!

So a clash is coming as I believe that central banks such as the ECB are happy for yields to rise now so they can act again later and claim success. The problem is two-fold. If it is so good why do we always need more and secondly how does this work with rising inflation trends?

 

Why would the Bank of England cut interest-rates right now?

Today sees the publication of the Queen’s Speech in Parliament which will deal with issues of fiscal policy but I wish to look at the consequences for monetary policy. After all monetary policy was something which did not get much of an airing in the election debates because it is accepted that this is now controlled by the Bank of England. Actually there is a technical problem with that as it needs permission from the Chancellor of the Exchequer for its QE (Quantitative Easing) program. Also it is rather a moot point as to how different UK monetary policy would be if we had politicians in charge as they would have eased policy considerably too. On that road you find yourself facing the fact that any argument for “independence” at the Bank of England involves them being able to ease monetary policy by more than politicians would have done! Was that the whole (political) plan all along?

The case for a Bank Rate Reduction

Regular readers will be aware that I have argued since December 2013 that a Bank Rate cut is as least as likely as a rise. This is of course against the consensus because the “Forward Guidance” of the Bank of England promises a rise. But I would like to visit the Ivory Tower of Professor Wren-Lewis to examine his case for a Bank Rate cut. His view is that we have a large output gap right now and that we should use monetary policy to help close it.

The most basic thing we know about the UK economy is that output is now something like 15% below where it should be if pre-recession trends had continued. For the UK that pre-recession trend had been remarkably stable………So it is possible that the scope for additional expansion is large. This is real uncertainty, but it is also one sided uncertainty. No one is seriously suggesting the economy is running at 5% above trend, let alone 15%!

We also have a discussion on inflationary trend where the good Professor seems to have confused himself so let us move quickly onto productivity which he also feels would improve with a demand boost via a rate cut.

but such improvements would come quickly if demand picked up enough (and labour became scarce). Again the risks here seem one-sided.

If we combine the two factors then it is clear as to why the Professor argues strongly for a Bank Rate cut now.

In these circumstances, the obvious thing to do, as well as the cautious and prudent thing to do, is to cut rates now to cover for the possibility that the output gap is actually much larger than estimated and inflation will therefore not return to target as hoped.

There you have it in a nutshell. There are other cases for a UK interest-rate cut which involve raising the inflation target to 4% per annum made by other Professors but I will respond to those by simply pointing out UK economic history.

Let me add a case which is not made by the Professor which is the strength of the UK Pound £ exchange-rate. He seems unclear about its impact so let me help him out. We have seen a surge in the value of the UK Pound since the nadir of March 2013 and in fact have even risen above the level it was at when Lehman Brothers collapsed. Using the old Bank of England rule of thumb the rise has been equivalent to a 3.5% increase in Bank Rate. Care is needed as it is only a rule of thumb but it does indicate a clear tightening over the past couple of years.

The argument against

The simplest is that if we move from an Ivory Tower world of official interest-rates to the world in which we live interest-rates have been falling since the implementation of FLS or the Funding for (mortgage) Lending Scheme in July 2012.  For example the 2 year fixed rate mortgage (90% LTV) fell from over 6% in early 2012 to 3.53% at the end of April according to the Bank of England. Which influences the economy more Bank Rate or mortgage rates? There is perhaps an answer in the fact that Bank Rate has not changed for six years.

Accordingly we already have a much more complex environment than the Ivory Tower simplicity of pulling a Bank Rate lever. For our trading companies life has got harder overall via a currency rise whilst for the housing and consumer sector it has got easier. Along this road of course we do get the worries about rising household debt and unsecured lending which I note do not get a mention in the case for an interest rate cut.

Next we have the issue that the economy is growing rather solidly right now and of course has just received a boost from the oil price drop.

GDP was 2.4% higher in Quarter 1 (Jan to Mar) 2015 compared with the same quarter a year ago.

It was not so long ago that such a rate of growth would have led for calls for a consideration of monetary tightening and not a cut! I wonder what rate of growth would now be enough?

Are we targeting inflation or economic growth?

I note the use of the “deflation” spectre by the Professor. This links to an article by David Blanchflower on the subject which seems to predict the end of the world as we know it on the basis of one monthly CPI annual print of -0.1%. What about the years of above target inflation? Or these issues?

The all items RPI annual rate is 0.9%, unchanged from last month.

UK house prices increased by 9.6% in the year to March 2015, up from 7.4% in the year to February 2015.

So on these measures we have a mild slow down in inflation and a rampant episode of asset price inflation. Are they the new definition of deflation? We should be told if so especially as the major price fall (oil) is one about which we can hardly defer purchases unless someone can show me a way of doing that with my car when it runs out of diesel or domestic heating?

So we have a clear issue which is that when economic growth is poor and inflation high we are told we need an interest-rate cut because of growth. Now we have low inflation and much better growth we need a rate cut because inflation is low. The Starship Enterprise would be on red alert with such asymmetry.

The Output Gap

In many ways this blog opened as an argument against the output gap and I was proven to be correct. Accordingly after the years of pain for its adherents when inflation was supposed to collapse and instead went above 5% per annum which was quite an anti-achievement in my opinion you might expect some revisions. For example an acceptance that some and worryingly much of the pre credit crunch boom was as the band Imagination put it.

Just An Illusion

Instead just like The Terminator it is apparently back! Sadly nothing appears to have been learned.In my opinion there is no trend anymore as the pre credit crunch period has gone and we need to adjust to that otherwise we run the risk of making the mistake that Japan made that somehow it might come back.

Another issue with saying output has a gap is this.

In quarter 1 January to March 2015, the UK’s deficit on trade in goods and services was estimated to have been £7.5 billion; widening by £1.5 billion from the previous quarter.

Inflation

Tucked away in the interest-rate cut analysis is a completely different view of the economic damage inflicted by bursts of inflation on the ordinary person, worker and consumer.

The worst that can happen if this is done is that rates might have to rise a little more rapidly than otherwise in the future, and inflation might slightly overshoot the 2% target.

Borrowing from the future as the can gets kicked again? However if I may just stick with the inflation point this is a repetition of the output gap error made in 2009/10/11 again as “slightly overshoot” became 5% per annum inflation and begat a collapse in real wages. That road forwards became this as real wage falls became a depressionary influence on the UK economy.

We’re on a road to nowhere

Anyway aren’t services four-fifths of our economy?

The CPI all services index annual rate is 2.0%……The all services RPI annual rate is 1.8%

Cutting interest-rates is a trap

The problem with cutting official interest-rates is that you end up in the situation described by Coldplay.

Oh, no, what’s this?
A spider web, and I’m caught in the middle,
So I turned to run,
The thought of all the stupid things I’ve done,

We cut from 5% to an emergency rate of 0.5% and now we need to cut again apparently. So is this a worse emergency? This would need quite an explanation right now! Especially if you throw in the fact that back then we got quite a boost from a lower pound too. Overall monetary policy is very loose and if you throw everything into the pot (QE etc) what would you say the Bank Rate equivalent is -5%?

Now we get to the difficult bit. The first part is that via the effect on savers interest-rate cuts here have only a small effect and may have a reverse effect. Secondly as we keep cutting and debt rises in response how can we ever raise rates again without a collapse?So we cut again as we find ourselves in the spider’s web described by Coldplay.

Comment

If Professor Wren-Lewis is correct and we can improve things by pulling a lever then it is time for one of the Beach Boys hits.

Wouldn’t it be nice

Maybe if we think and wish and hope and pray it might come true
Baby then there wouldn’t be a single thing we couldn’t do.

Except if pulling levers like that did work we wouldn’t be where we are would we?