Issue: March / May 2013

Silver bullet or poison pill?

There are two sides to continued monetary easing. Chris Hamman, head of fixed interest at Sanlam Investment Management, discusses them.

When economic activity is depressed, central banks are inclined to ease monetary policy to boost investment. Rising investment in turn creates employment, which sets the tone for a recovery. But is continued monetary easing – pushing interest rates towards zero percent – really desirable?

The justification for lowering interest rates during depressed economic times is straightforward. It is a virtuous and appealing story. But economic stories rest on assumptions and often the better the story, the more favourable the underlying assumption.

Sub-prime lending in the US was just such a good news story. The positive final contribution to the US economy was always premised on the assumption that house prices would rise infinitely. Initially that assumption seemed reasonable. After all, US house prices had risen progressively since 1940. However, in 2007 the assumption regrettably proved too favourable and, as house prices dropped, the subprime market collapsed. What started as a good news story triggered a downward correction to the global economy that continues today.

Similarly, the idea that lower interest rates will stimulate investment rests on two important assumptions: firstly, that interest rates will remain at lower levels for a prolonged period; secondly, that the cash flows generated by projects will be sufficiently positive to meet their funding obligations. Alas, on closer examination, these assumptions appear onerous.

Starting with the interest rate level, it is noteworthy that SA 10-year government bonds are less than 7%. In nominal terms, they are roughly at their lowest level since the late 1960s. More important, with inflation having averaged 5,3% over the past decade (and 8% a year for five decades), you can rightfully question whether the present benchmark level is, indeed, sustainable. After all, why would anyone commit capital to a project with an uncertain outcome if, after adjusting for inflation, the return is almost zero? Thus further easing may not stimulate investment.

The cash-flow assumption is equally troublesome. By citing a depressed economic outlook as the primary reason for lowering interest rates, the central bank is cautioning investors that the profit outlook is bleak. To then lower interest rates to multi-generational lows, as they have done in SA, or multi-century lows like in the US, the monetary authorities are signalling that profit expectations ought to be scaled back even further. Rational investors will not fund projects when the potential returns are declining amid lower interest rates, while the riskiness of potential projects may be rising in the face of increased economic uncertainty. Lowering short-term interest rates to extraordinary low levels may, therefore, not be the silver bullet it is made out to be.

Why then lower interest rates when the result is tantamount to pushing on a piece of string? As it turns out, very low interest rates do impact on the economy, but in a different way to what people expect – the public sector seems to be the benefactor. In the short term, extraordinary low interest rates protect political incumbents in much the same manner that a poison pill protects corporate insiders against hostile outside shareholders. A poison pill occurs when the target company takes steps to make the share price less attractive to the acquirer. This protection may, however, come at the expense of long-term economic performance.

To see how the mechanism works, consider that investors generally prefer safer investments over risky investments if the returns are expected to be similar. Government bonds are regarded as riskfree compared to other investments. So, when interest rates are at very low levels, you would expect to see money flowing into government bonds at the expense of other investments. For the public sector, this is fortunate because government spending tends to exceed tax revenue when economic activity is depressed and the resultant deficits need to be funded by issuing debt.

While rising public spending may be popular with voters (salaries of civil servants make up the bulk of the spending), the rising interest burden associated with deficits and increased indebtedness is politically problematic. Every rand spent on interest payments is a rand not spent on service delivery. Bureaucrats and civil servants alike will therefore aim to minimise interest payments. Since these payments rise with interest rates and the size of the budget deficit, and tax revenue rises only slightly faster than inflation, policy makers may seek to set the interest rate at or below the inflation rate.

Although a strategy of keeping interest rates low may not prevent the debt-to-GDP ratio and the interest bill from rising, it may go a long way in keeping the adverse trend in check. Thus, a government that implements unsustainable policies may be able to cover its tracks.

Unfortunately there is a cost associated with lowering interest rates towards zero. Over time, this cost (in the form of a declining potential growth rate) accrues to the economy as a whole and, in particular, to longterm investors who forego reasonable returns.

Because investors are a diverse group, their voice is not as loud as that of direct beneficiaries of government spending. As a result, the economic cost of low interest rates may be underestimated, at least initially. Over the longer term, however, investors have always lost confidence in governments that fail to implement prudent policies. When confidence disappears, domestic financial markets (which can be regarded as a national asset) at the mercy of its persecutors and incumbents, may find that policy gets dictated by outsiders.

Ultimately the aim of macroeconomic policy should be to create an environment conducive to long-term economic growth and wealth creation. To the extent that continued monetary easing is inconsistent with this objective, extraordinarily low interest rates may therefore be undesirable.

For more investment insight, visit