In the years since the 2008 crisis, there is no question in finance that has caused more angst among investors, analysts and even onlookers than what to do about "abnormally low" interest rates. In 2009 and 2010, the response was that rates would revert back quickly to normal levels, once the crisis had passed. In 2011 and 2012, the conviction was that it was central banking policy that was keeping rates low, and that once banks stopped or slowed down quantitative easing, rates would rise quickly. In 2013 and 2014, it was easy to blame one crisis or the other (Greece, Ukraine) for depressed rates. In 2015, there was talk of commodity price driven deflation and China being responsible for rates being low. With each passing year, though, the conviction that rates will rise back to what people perceive as normal recedes and the floor below which analysts thought rates would never go has become lower. Last year, we saw short term interest rates in at least two currencies (Danish Krone, Swiss Franc) become negative and this year, the Japanese Yen joined the group, with rumors that the Euro may be the next currency to breach zero. While it has been difficult to explain the low interest rates of the last few years, it becomes doubly so, when they turn negative. I would be lying if I said that negative interest rates don't make me uncomfortable, but I have had to learn to not only make sense of them but also to live with them, in valuation and corporate finance. This post is a step in that direction.
Setting the table
There are a handful of currencies that have made the negative interest rate newswire, but it is worth noting that the rates that are being referenced in many of these stories are rates controlled by central banks, usually overnight rates for banks borrowing from the central bank. In March 2016, there were two central banks that had set their controlled rates below zero (Switzerland and Sweden) and two more (ECB and Bank of Japan) that had set the rate at zero. (Update: The ECB announced that it would lower its rates below zero on March 10.)
Note that these are central bank set rates and that short and long term market interest rates in these currencies can take their own path. To provide a contrast, consider the Japanese Yen and Euro, two currencies where the central banks have pushed the rates they control to zero. In both currencies, short term market interest rates have in fact turned negative but only the Yen has negative long term interest rates:
In a post from earlier this year, I looked at long term (ten-year) risk free rates in different currencies, starting with government bond rates in each currency and then netting out sovereign default spreads for governments with default risk. Updating that picture, the government bond rates across currencies on March 9, 2016, are shown below:
Joining the Japanese Yen is the Swiss Franc in the negative long term interest rate column. Why make this distinction between central bank set rates, short term market interest rates and long term interest rates? It is easier to explain away negative central bank set rates than it is to explain negative short term interest rates and far simpler to provide a rationale for negative rates in the short term than negative rates in the long term. Thus, there have been episodes, usually during crises, where short term interest rates have turned negative, but this is the first instance that I can remember where we have faced negative long term rates on two currencies, the Swiss Franc and the Japanese yen, with the very real possibility that they will be joined by the Euro, the Danish Krone, the Swedish Krona and even the Czech Koruna in the near future.
Setting the table
There are a handful of currencies that have made the negative interest rate newswire, but it is worth noting that the rates that are being referenced in many of these stories are rates controlled by central banks, usually overnight rates for banks borrowing from the central bank. In March 2016, there were two central banks that had set their controlled rates below zero (Switzerland and Sweden) and two more (ECB and Bank of Japan) that had set the rate at zero. (Update: The ECB announced that it would lower its rates below zero on March 10.)
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| February 2016 |
In a post from earlier this year, I looked at long term (ten-year) risk free rates in different currencies, starting with government bond rates in each currency and then netting out sovereign default spreads for governments with default risk. Updating that picture, the government bond rates across currencies on March 9, 2016, are shown below:
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| Ten-year Government Bond Rates - March 9, 2016 |
Interest Rates 101
I am not a macroeconomist, have very little training in monetary economics and I don't spent much time examining central banking policies. Keep that in mind as you read my perspective on interest rates, and if you are an expert and find my views to be juvenile, I am sorry. That said, I have to process negative interest rates, using my limited knowledge of what determines interest rates.
Intrinsic and Market-set Interest Rates
When I lend money to another individual (or buy bonds issued by an entity), there are three components that go into the interest rate that I should demand on that bond. The first is my preference for current consumption over future consumption, with rates rising as I value current consumption more. The second is expected inflation in the currency that I am lending out, with higher inflation resulting in higher rates. The third is an added premium for any uncertainty that I feel about not getting paid, coming from the default risk that I see in the borrower. When the borrower is a default-free entity, there are only two components that go into a nominal interest rate: a real interest rate capturing the current versus future consumption trade off and an expected inflation rate.
How do you reconcile these two worlds? To the extent that those demanding bonds are motivated by the need to earn interest that covers the expected inflation and generate a real interest rate, you could argue that in the long term, the intrinsic rate should converge on the market set rate.
In the short term, though, as with any financial asset, there is a real chance that the market-set rate can be lower or higher than the intrinsic rate. What can cause this divergence? It could be investor irrationality, where bond buyers overlook their need to cover inflation and earn a real rate of return. It could be a temporary shock to the supply or demand side of bonds that can cause the market-set rate to deviate; this is perhaps the best way to think about the "flight to safety" that occurs during every crisis, resulting in lower market interest rates. There is one more reason and one that many investors seem to view as the dominant one and I will address it next.
Intrinsic and Market-set Interest Rates
When I lend money to another individual (or buy bonds issued by an entity), there are three components that go into the interest rate that I should demand on that bond. The first is my preference for current consumption over future consumption, with rates rising as I value current consumption more. The second is expected inflation in the currency that I am lending out, with higher inflation resulting in higher rates. The third is an added premium for any uncertainty that I feel about not getting paid, coming from the default risk that I see in the borrower. When the borrower is a default-free entity, there are only two components that go into a nominal interest rate: a real interest rate capturing the current versus future consumption trade off and an expected inflation rate.
Nominal Interest Rate = Real Interest Rate + Expected Inflation Rate
This is, of course, the vaunted Fisher equation. There is an alternate view of interest rates, where the interest rate on long term bonds is determined by the demand and supply of bonds, and it is shifts in the demand and supply that drive interest rates:
How do you reconcile these two worlds? To the extent that those demanding bonds are motivated by the need to earn interest that covers the expected inflation and generate a real interest rate, you could argue that in the long term, the intrinsic rate should converge on the market set rate.
In the short term, though, as with any financial asset, there is a real chance that the market-set rate can be lower or higher than the intrinsic rate. What can cause this divergence? It could be investor irrationality, where bond buyers overlook their need to cover inflation and earn a real rate of return. It could be a temporary shock to the supply or demand side of bonds that can cause the market-set rate to deviate; this is perhaps the best way to think about the "flight to safety" that occurs during every crisis, resulting in lower market interest rates. There is one more reason and one that many investors seem to view as the dominant one and I will address it next.
The Central Bank and Interest Rates
In all of this discussion, notice that I have studiously avoided bringing the central bank into the process, which may surprise you, given the conventional wisdom that central banks set interest rates. That said, a central bank can affect interest rates in one of two ways:
Measuring the Fed Effect
Just ahead of the Federal Open Market Committee meetings last year, as debate about whether the Fed would ease up on quantitative easing, I argued that we were over estimating the effect that the Fed had on market set rates and that while it has contributed to keeping rates low for the last six years, an anemic economy was the real reason for low interest rates. To compute the Fed effect, I chose to track two numbers:
In all of this discussion, notice that I have studiously avoided bringing the central bank into the process, which may surprise you, given the conventional wisdom that central banks set interest rates. That said, a central bank can affect interest rates in one of two ways:
- The first and more conventional path is for the central bank to signal, through its actions on the rates that it controls what it thinks about inflation and real growth in the future, and with that signal, it may alter long term rates. Thus, the Fed lowering the Fed funds rate (a central bank set rate that banks can borrow from the Fed Window) will be viewed as a signal that the Fed sees the economy as weaken and expects inflation to stay subdued or even non-existent, and this signal will then push expected inflation and real interest rates down. This will work only if central banks are credible in their actions, i.e., they are viewed as acting in good faith and with good information and are not gaming the market.
- The second channel is for the central bank to actively enter the bond market and buy or sell bonds, thus affecting the demand for bonds, and interest rates. This is unusual but it is what central banks in the United States and the EU have done since 2008 under the rubric of quantitive easing. For this to have a material effect on interest rates, the central bank has to be a big enough buyer of bonds to make a difference.
Measuring the Fed Effect
Just ahead of the Federal Open Market Committee meetings last year, as debate about whether the Fed would ease up on quantitative easing, I argued that we were over estimating the effect that the Fed had on market set rates and that while it has contributed to keeping rates low for the last six years, an anemic economy was the real reason for low interest rates. To compute the Fed effect, I chose to track two numbers:
- An intrinsic interest rate, computed by adding together the actual inflation each year and the real growth rate each year, two imperfect proxies for expected inflation and the real interest rate.
- The ten-year US treasury bond rate at the start of each year, set by the bond market, but affected by expectation setting and bond buying by the Fed.
The graph below captures both numbers, updated through 2015:
Note how closely the US treasury bond has tracked my imperfect estimate of the intrinsic interest rate, and how low the intrinsic rate has become, post-crisis. At the risk of repeating myself, the Fed has, at best, had only a marginal impact on interest rates during the last six years and it is my guess that rates would have stayed low with or without the Fed during this period.
Note how closely the US treasury bond has tracked my imperfect estimate of the intrinsic interest rate, and how low the intrinsic rate has become, post-crisis. At the risk of repeating myself, the Fed has, at best, had only a marginal impact on interest rates during the last six years and it is my guess that rates would have stayed low with or without the Fed during this period.
Negative Interest Rates
Turning to the question at hand, is it possible for nominal interest rates to be negative, based upon fundamentals? The answer is yes, but with a caveat. If the preference for current consumption over future consumption dissipates or gets close to zero and you expect deflation in a currency, you could end up with a negative interest rate. In fact, that is the common thread that runs through the economies (Japan, the Euro Zone, Switzerland) where rates have become negative.
Now, comes the caveat. If you have nominal negative interest rates, why would you ever lend money out, since you have the option of just holding on to the money as cash. Historically, that has led many to believe that the floor on nominal rates should be zero. As rates go below zero, it is time to reexamine that belief. One way to reconcile negative interest rates with rational behavior is to introduce costs to holding cash and there are clearly some to factor in, especially in today's economies. The first is that while the proverbial stuffing cash under your mattress option is thrown around as a choice, you will increase your exposure to theft and may have to invest in security measures that are costly. The second is that there are some transactions that are extraordinarily cumbersome to get done with cash; imagine buying a million dollar house and counting out the cash for the payment. The Danish, Swiss and Japanese governments are embarking on a grand experiment, perhaps, of how much savers will be willing to pay for the convenience of staying cashless. In effect, the lower bound has shifted below zero but there is still one. To those who are convinced that negative interest rates have nothing to do with fundamentals and that they are entirely by central bank design, I would argue that the only reason that these central banks have been able to push rates below zero, is because real growth and inflation have become so low in their economies that the intrinsic rate was close enough to zero to begin with. There is no chance that the Brazilian and Indian central banks will follow suit.
Turning to the question at hand, is it possible for nominal interest rates to be negative, based upon fundamentals? The answer is yes, but with a caveat. If the preference for current consumption over future consumption dissipates or gets close to zero and you expect deflation in a currency, you could end up with a negative interest rate. In fact, that is the common thread that runs through the economies (Japan, the Euro Zone, Switzerland) where rates have become negative.
Now, comes the caveat. If you have nominal negative interest rates, why would you ever lend money out, since you have the option of just holding on to the money as cash. Historically, that has led many to believe that the floor on nominal rates should be zero. As rates go below zero, it is time to reexamine that belief. One way to reconcile negative interest rates with rational behavior is to introduce costs to holding cash and there are clearly some to factor in, especially in today's economies. The first is that while the proverbial stuffing cash under your mattress option is thrown around as a choice, you will increase your exposure to theft and may have to invest in security measures that are costly. The second is that there are some transactions that are extraordinarily cumbersome to get done with cash; imagine buying a million dollar house and counting out the cash for the payment. The Danish, Swiss and Japanese governments are embarking on a grand experiment, perhaps, of how much savers will be willing to pay for the convenience of staying cashless. In effect, the lower bound has shifted below zero but there is still one. To those who are convinced that negative interest rates have nothing to do with fundamentals and that they are entirely by central bank design, I would argue that the only reason that these central banks have been able to push rates below zero, is because real growth and inflation have become so low in their economies that the intrinsic rate was close enough to zero to begin with. There is no chance that the Brazilian and Indian central banks will follow suit.
Interest Rates, Financial Assets and the Real Economy
When central banks in these currencies strongly signal their intent to drive interest rates to zero and below, what could be the motivation? Put simply, it is the belief that lower interest rates lead to higher prices for financial assets and more real investment in the economy, either through the mechanism of "lower" hurdle rates for investments or a weaker currency making businesses more competitive globally. In this central banking heaven, where central banks set rates and the world meekly follows, this is what unfolds:
So, why has it not worked? As interest rates in the US, Europe and Japan have tested new lows each year for the last few, we have not seen an explosion in real investment in these countries, and while stock prices have risen, the rise has had as much to do with higher earnings and cash flows, as it has to do with lower interest rates. In my view, the fundamental miscalculation that central banks have made is in assuming that their actions not only affect other pieces of this puzzle but are also read as signals of the future. In particular, central bankers have failed to incorporate three problems: that interest rates do not always follow the central bank lead, that risk premiums on equity and debt may increase as rates go down and that exchange rate effects are muted by other central banks acting at the same time. In this reality-based central banking universe, the lowering of rates by central banks can have unpredictable and often perverse consequences, lowering financial asset prices, reducing real investment and making a currency stronger rather than weaker.
This is all hypothetical, you may say, but there is evidence that markets have become much less trusting of central banking and more willing to go their own ways. For instance, as the risk free rate has dropped over the last few years, note that the expected return for stocks has stayed around 8% during that period, leading to higher and higher equity risk premiums.
While bond markets initially did not see this phenomenon, last year default spreads on bonds in every ratings class widened, even as rates dropped. Interestingly, the most recent ECB announcement that they would push the rates they control lower was accompanied by news that they would enter the bond market as buyers, hoping to keep default spreads down. That is an interesting experiment and I have a feeling that it will not end well.
So, why has it not worked? As interest rates in the US, Europe and Japan have tested new lows each year for the last few, we have not seen an explosion in real investment in these countries, and while stock prices have risen, the rise has had as much to do with higher earnings and cash flows, as it has to do with lower interest rates. In my view, the fundamental miscalculation that central banks have made is in assuming that their actions not only affect other pieces of this puzzle but are also read as signals of the future. In particular, central bankers have failed to incorporate three problems: that interest rates do not always follow the central bank lead, that risk premiums on equity and debt may increase as rates go down and that exchange rate effects are muted by other central banks acting at the same time. In this reality-based central banking universe, the lowering of rates by central banks can have unpredictable and often perverse consequences, lowering financial asset prices, reducing real investment and making a currency stronger rather than weaker.
This is all hypothetical, you may say, but there is evidence that markets have become much less trusting of central banking and more willing to go their own ways. For instance, as the risk free rate has dropped over the last few years, note that the expected return for stocks has stayed around 8% during that period, leading to higher and higher equity risk premiums.
While bond markets initially did not see this phenomenon, last year default spreads on bonds in every ratings class widened, even as rates dropped. Interestingly, the most recent ECB announcement that they would push the rates they control lower was accompanied by news that they would enter the bond market as buyers, hoping to keep default spreads down. That is an interesting experiment and I have a feeling that it will not end well.
Dealing with Negative Interest Rates
My interests in negative interest rates are primarily in the context of valuation and corporate finance. In both arenas, the hurdle rates we use to pick investments and value businesses build off a long term risk free rate as a base and having that base become a negative value is disconcerting to some. There are two choices that you have:
- Switch currencies: You can value Danish companies in Euros or US dollars, where long term rates are still positive (albeit very low). This evades the problem, but you can run but you cannot hide. At some point in time, you will have to work in the negative interest rate currency.
- Normalize risk free rates: This is a practice that has become more prevalent in both the US and Europe, where risk free rates have dropped to historic lows. To compensate, analysts are using the average rate across long periods as a normalized risk free rate. I have problems with this approach at three levels. The first is that normal is in the eye of the beholder and what you call a normal 10-year T.Bond rate is more a function of your age than scientific judgment. The second is that given that the risk free rate is where you plan to put your money if you don't make your real investment, it seems singularly dangerous for this to be a made-up number. The third is that using a normalized risk free rate with the high equity risk premiums that are prevalent today will lead to too high a hurdle rate, since the latter are primarily the result of low risk free rates.
- Leave the risk free rate negative: So, what if the risk free rate is negative? In valuation, you almost never use the risk free rate standing alone, but only in conjunction with a risk premium. If you can update those risk premiums, they may very well offset the effect of having a negative risk free rate and yield a cost of equity and/or debt that does not look different from what it did prior to the negative interest rate setting. There is one other adjustment that I would make. In stable growth, I have been a proponent of using the risk free rate as your cap on the stable growth rate. With negative risk free rates, I would stick with this principle, since, as I noted earlier in this post, negative interest rates signify economies with low or no real growth combined with deflation and the growth rate in perpetuity for stable companies in these economies should be negative for those same reasons.
What Real Negative Interest Rates Signify
When interest rates of from being really small positive numbers (0.25% or 0.50%) to really small negative numbers (-0.25% to -0.50%), the mathematical consequences are small but I do think that breaching zero has consequences and almost all of them are negative.
- The economic end game: For those who ultimately care about real economic growth and prosperity, negative interest rates are bad news, since they are incompatible with a healthy, growing economy.
- Central banks insanity, impotence and desperation: As I watch central bankers preen for the cameras and hog the limelight, I am reminded of the old definition of insanity as trying the same thing over and over, expecting a different outcome. After six years of continually trying to lower rates, with the expectation of economic growth just around the corner, it is time for central banks to perhaps recognize that this lever is not working. By the same token, the very fact that central banks revert back to the interest rate lever, when the evidence suggests that it has not worked, is a sign of desperation, an admission by central banks that they have run out of ideas. That is truly scary and perhaps explains the rise in risk premiums in financial markets and the unwillingness of companies to make real investments.
- Unintended consequences: As interest rates hit zero and go lower, there will be some investors, in need of fixed income, who will look in dangerous places for that income. A modern-day Bernie Madoff would need to offer only 4% in this market to attract investors to his fund and as I watch investors chase after yieldcos, MLPs and other high dividend paying entities, I am inclined to believe that is a painful reckoning ahead of us.
- An opening for digital currencies: In a post a few years ago, I looked at bitcoin and argued that there will be a digital currency, sooner rather than later, that meets the requirements of trust needed for a currency in wide use. The more central bankers in conventional currencies play games with interest rates, the greater is the opening for a well-designed digital currency with a dependable issuing authority to back it up.
In the next few weeks, I am sure that we will read more news stories about central banks professing to be shocked that markets have not done their bidding and that economies have not revived. I am not sure whether I should attribute these rantings to the hubris of central bankers or to their blindness to market realities. Either way, I feel less comfortable with the notion that central bankers know what they are doing and that we should trust them with our economic fates.
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This indeed a remarkable piece. You came round to very accurate macro economic explanation for the basis and operationalization of negative interest rate without really going into even basic macro economic model specifiers.. Kudos! In a way that is how it should be. If push comes to shove ( in other words you are having to write a paper and in that context understanding of zero bound, liquidity trap, secular stagnation, saving glut and wickesllian natural rate of interest become relevant, you can always team up with a macro guy! Period. Best Regards ..R Vasudevan
ReplyDeleteVery interesting post and thank you for putting what can be a complex topic into plain english! My focus, I think like your own, is how negative interest rates impact the intrinsic value of businesses as defined by the present value of their future cash flows.
ReplyDeleteI know from your other posts you have a proclivity for using WACC or something similar as a discount rate but having been immersed in corporate valuation since my college days I have come to think about discount rates differently and in a manner more consistent with what Charlie Munger would advocate i.e. my opportunity cost. To me this is the most logical rate at which to discount future cash flows - if I don't make this investment, what are my alternatives (I should be accounting for "risk" by using conservative cash flow estimates). I therefore think you unfairly dismiss option 2 (normalize risk free rates).
When you sit and consider an investment today I think you have to not only think about where else you could put that money today but also what other opportunities may exist in the future. As such, I feel it is reasonable to take a somewhat longer term view on risk free rates. Even if I am only looking at a period that is my lifetime surely that is going to be closer to the real outcome than only looking at a current snapshot? I realize this may not have the scientific precision of other methodologies but I would rather be approximately right than precisely wrong.
"Thus, the Fed lowering the Fed funds rate (a central bank set rate that banks can borrow from the Fed Window) will be viewed as a signal that the Fed sees the economy as weaken and expects inflation to stay subdued or even non-existent, and this signal will then push expected inflation and real interest rates down"
ReplyDeleteAh, the neo-Fisherian view. Most monetary policy experts would disagree with that line of thinking. See Sumner:
http://econlog.econlib.org/archives/2016/02/james_bullard_o.html
Very informative piece and really clarifies so many questions I have about interests rates. Thank you!
ReplyDeleteone question on point which was not that obvious to me:
1. "this reality-based central banking universe, the lowering of rates by central banks can have unpredictable and often perverse consequences, lowering financial asset prices, reducing real investment and making a currency stronger rather than weaker."
Why would it lower financial asset prices?
If Bond - than we are dividing by a lower figure to get to PV which would be higher.
If Stock - investors will borrow more and invest in the stock market driving up asset prices.
Thank you. Very informative piece and clarifies a lot of questions I have about interest rate.
ReplyDeleteOne point that I did not fully get " In this reality-based central banking universe, the lowering of rates by central banks can have unpredictable and often perverse consequences, lowering financial asset prices, reducing real investment and making a currency stronger rather than weaker."
Why would it lower financial asset prices? Don't we see evidence of the contrary in the market today.
Good post. Bitcoin, however, doesn't have much chance since it cannot be measured and backed by assets. I guess it is for the hopefuls and those who have only trust, not control. I find trust to be good, but control is better.
ReplyDeleteIf the lowering of rates by a central bank are viewed as a sign that the economy is in bigger trouble than you thought is was, the risk premiums for debt and equity can go up by more than rates go down. Net result. Stock and bond prices will drop, not go up, as central banks lower rates.
ReplyDeleteIt is fair so far the treatment that you give to the negative free rate in the context of the perpetual growth of a company. Very helpful.
ReplyDeleteIf I understand it correct, you are saying that cost of capital has not fall despite negative risk free rate. This because risk premium more than compensates for the fall the negative risk free rate. But has return on market, a part of risk premium, not fallen (since the stock and bond prices have fallen)And if yes it would lead to lower risk premium.
ReplyDeleteIf central banks don't lower rates, they are effectively tightening as other central banks lower theirs. And you've seen what happens with the USD when they raise it just a little.
ReplyDeleteAlso I think a big driver of interest rates is prices of interest rate spreads. As central banks change near-term interest rates, spread traders will propagate that change toward the longer-term rates.
Sid,
ReplyDeleteWhen stock and bond prices fall, equity risk premiums and default spreads go up.
Sir, would it not be more correct to say that beta of the stocks increases (in such cases) in place of saying that equity risk premium goes up?
ReplyDeleteSid,
ReplyDeleteThe answer is no, since the average beta is always one. Hence, the betas for all stocks cannot increase.
Prof, your argument regarding intrinsic interest rate holds perfectly well for US markets. However, for an emerging market like say, India, it has not worked that well. If you take real growth rate and inflation rate year on year for India and compare to the government bond rate, the gap is pretty large. Could you please explain why? Thanks.
ReplyDeleteThank you for another excellent post, professor. Only one question and sorry if this information is already on your website: in your estimate/calculation of historic equity risk premiums, can you help me understanding how you determined the "Expected Return on Stocks"? Thank you!
ReplyDelete"If the lowering of rates by a central bank are viewed as a sign that the economy is in bigger trouble than you thought is was, the risk premiums for debt and equity can go up by more than rates go down. Net result. Stock and bond prices will drop, not go up, as central banks lower rates."
ReplyDeleteThis isn't borne out in the data that I've seen. Interest rate cuts that take the market by surprise virtually always see a spike in asset prices. The idea that interest rate cuts are contractionary (aka the Neo-Fisherian view) just doesn't have any evidence behind it. Your theory implies that the Fed knows something the market doesn't, but usually it's the exact opposite
Sir,
ReplyDeleteI was looking on your views regarding the new negative interest rate regimes. Negative interest rates are the new experiment in the Central Banking. However, I am very confused as to how this will prop up real economy?
The asset bubbles it would lead to afterwards seems to be massive as the same was happened when US tried QE as most of the benefit of it transferred in propping up asset prices. As far as real economy is concerned, the corporates and individual businesses will not simply invest their free cash on the sole reason of low interest rates.
Would like to have your take on this issue.
Thanks
Anonymous,
ReplyDeleteMy statement on the market reaction to interest rate cuts by the central bank is a conditional one. I said that if markets view a cut in rates as a sign that things are worse than expected, stock and bond prices will go down. Your point about the data not backing that up is true for the United States for much of the last century. If you go outside the US, there is evidence that repeated rate cuts do more damage than good to financial asset markets in Japan and Europe, and even within the US, the Fed's capacity to move markets has become much, much weaker since 2008. In fact, almost every assessment of the Fed effect is dramatically different if you look at the period prior to 2008 and post-2008.
Didn't the ECB take their deposit rate from -30 bps to -40 bps last week? As such weren't they already negative?
ReplyDeleteYou are right. The ECB did push their rate from -30 basis points to -40 basis points last week and I think I have a note to that effect in the post.
ReplyDelete"If you go outside the US, there is evidence that repeated rate cuts do more damage than good to financial asset markets in Japan and Europe"
ReplyDeleteAgain, I think you're mixing cause and effect here. Japan has had to cut rates *because* the economy has been so dismal, not vice versa. I would make the argument that the natural rate of interest is so low in Japan that even the low interest rates they had through the 2000's were keeping conditions far too tight.
The recent, much-discussed Beckworth/Ponnuru article in the NYT does a good job explaining that interest rates at their face value mean little, it is the spread between the natural / wicksellian interest rate and the target rate that determines whether money is tight or loose.
Bernanke argues the same thing:
"The imperfect reliability of money growth as an indicator of monetary policy is unfortunate, because we don't really have anything satisfactory to replace it. As emphasized by Friedman (in his eleventh proposition) and by Allan Meltzer, nominal interest rates are not good indicators of the stance of policy, as a high nominal interest rate can indicate either monetary tightness or ease, depending on the state of inflation expectations. Indeed, confusing low nominal interest rates with monetary ease was the source of major problems in the 1930s, and it has perhaps been a problem in Japan in recent years as well."
and from Mishkin's textbook (THE book on monetary policy):
"1. It is dangerous always to associate the easing or the tightening of monetary policy with a fall or a rise in short-term nominal interest rates.
2. Other asset prices besides those on short-term debt instruments contain important information about the stance of monetary policy because they are important elements in various monetary policy transmission mechanisms.
3. Monetary policy can be highly effective in reviving a weak economy even if short term rates are already near zero."
A few comments:
ReplyDeleteThere's another driver for long term rates which you don't mention. That is the assumed cost of funding, stemming from no-arb markets theory. I.e. Say that for term T, inflation is X, and real-rate demanded by investors is Y. So you have I = X+Y. But if the short-term rate is S << I, and the CBs indicate that for a large part of T (if not whole of T) S is going to be the same, then there's an abitrage profit to be made by buying the bond with yield I and funding it at rolled S (or S + short-term funding spread). Of course, you're running a risk of CB lying (SNB Jan 2015 is an example), and you getting hit regardless, but again, if swaps are cheap, you may be able to hedge the your funding there.
Which of the drivers takes the driving seat depends on their market strenghts. Given that speculators trade more often than real money, and in general are more active in just about all but commodities, I believe that it's currently more likely that the yields are driven by the short rates rather than inflation or whatever else.
Second point is re CBs driving investment. CB's are detached from reality, because in reality the decision of a project to go/not go is not determined by costs alone, but by potential revenues. Reducing costs may make some marginal project viable, ceteris paribus. But there's never ceteris. So, in an environment where demand is slowing considerably, reducing costs marginally is unlikely to be enough to make even marginal projects interesting. Definitely not unless you reduce your expected RoI substantially. But if your expected RoI was say 15% before 2008, with 5% long-term rates, you have 10% of risk premia. If the project was not started at 2% long term rates, it's unlikely that reducing the long term rates to 0% will start it, especially if it's accompanied by the projections of demand going down by say 3-5% (which is the difference between economy growing at 3-5% and being flat). Talk about pushing a string.
The projects that low rates will encourage are thus those where a formal estimate of RoI and viability is not done (or cannot be done with any degree of accuracy, and that's saying something) - like buying more rental flats, startup investing, anything that can generate a lots of cash up front in exchange for a huge debt load etc. - the very riskiest stuff. Some of this may very well pay out long term, but the payout is likely concentrated to a specific group of people (house owners with mortgages, landlords, some VCs/startup founders etc.), which is not necessarily a good outcome either.
Thank you for a nice article. A follow-up could deal with the role of the central banks more fully. What have they achieved and what motivates them? Since most of them operate in an explicit or implicitly unaccountable space and they control such vast amounts, these are questions that any democracy need to be answered, particularly in the context of a financial sector that is out of control. Tim Exall
ReplyDeleteMore on recent rate moves + market reactions:
ReplyDeletehttp://econlog.econlib.org/archives/2016/03/the_medias_blin.html
I don't think there's any argument to be made that interest rate cuts aren't expansionary (a good thing, since it would fly in the face of macro theory). Markets always react to unexpected rate cuts by pushing asset prices up.
Just because someone writes it in an economists' blog does not make it true. If it were, we should be in the middle of astonishing economic growth, after six years of rate cuts. And only people who do not understand and respect markets (and I include many academic economists in this camp) use words like always, when it comes to market behavior. An unexpected rate cut always causes stock prices to rise: Really? What absolute nonsense? (Look at the rate cuts that happened between October and December of 2008 for simple counter examples)
ReplyDeleteIt is great post and some great responses from Professor Aswath Damodaran. Professor might be interested to note that Raghuram Rajan holds not-so-dissimilar views and he may also find thes two blog posts by Noah Smith in Bloomberg - great reads:
ReplyDeletehttp://www.bloombergview.com/articles/2014-11-04/reality-might-topple-a-beloved-economic-theory
and http://www.bloombergview.com/articles/2016-03-10/an-economics-laboratory-where-theories-go-to-die
The anonymous gentleman/woman who suggests that low interest rates always lead to deterministic outcomes has forgotten the basic lesson of economic theories. They are valid as long as everything else stays constant. But, nothing ever stays constant. There is unintended signalling from negative interest rates. If real rates are constant and are determined by consumption and social preferences, negative policy rates must result in expected deflation.
Further, empirical evidence (Federal Reserve discussion paper from Dec. 2013) is that corporate CFOs rarely bring down their hurdle rates when interest rates drop. So, investment spending does not respond to lower interest rates as much as theory would predict. IT is consumer spending that is sought to be given a push.
Whether that is desirable in the US context is entirely debatable.
It is good that Prof. Aswath Damodaran has lent his considerable intellectual reputation to the cause of righting hubristic monetary policies. World over, monetary policymakers can do with a lot less certitude and with lot more mindfulness of the law of unintended consequences.
In your title, you ask the question of whether rates are "unnatural", and you come close to answering in the "...signify" section, but in the end are inconclusive.
ReplyDeleteThe key, I think, is the realization that while central bankers are clearly not impotent, they are not central planners. In fact, they are conservative and reactive, while also being over-optimistic and negligent or ignorant of risks. They don't set interest rates so much as have their decisions guided by developments, many outside of their control; I think you got that much right when you brought them into the picture. They look like they are active, but they are in fact timid -- think about the BoE leaving rates at 0.50%, and the Fed's premature withdrawals of QE1 and QE2.
Kocherlakota's blog-posts are a good read, and illustrate that negative rates are in fact, as you suggest, a pretty small change from low but positive rates. A bit of extra policy space, but no game changer: that would mean helicopter drops and/or fiscal policy. Again, Bernanke's 2002 speech reminded EVERYONE that this should be that natural way to go. And chronically low or negative rates are a result of, not a cause of (a) previous monetary failures and (b) current conditions including fiscal settings and private sector actions. Negative rates and QE are a normal -- not an abnormal -- setting when the demand for savings is high and the willingness/ability to invest is low. That's the reality today. Change that and rates will go up.
Great post Professor! About risk premiums I would just like to add that QE had done enough to inflate asset prices like equities thereby compressing risk premiums and probably making them run above their fundamentals. Negative rates possibly can't lift asset prices since QE already did it and thus we see equities falling and risk premiums widening yet again. If QE and NIRP had initially come together but in a stable manner risk premiums could've actually fallen. Anyway it's anybody's guess and hindsight views! Thanks again for the post Professor!
ReplyDeleteAmruth,
ReplyDeleteNot a bad argument but one fundamental problem. If risk premiums are compressed, where is the evidence that they are? My implied ERP has remained stubbornly high for the last six years.
Professor,
DeleteThanks for your reply and sorry for my late reply! I looked up the excel sheet of yours in which the ERPs were given. Taking the average ERP from 2008-'15 (post crisis stage) shows that the ERPs post the move into QE in two stages of QE from 2009-11 (QE1) and in 2013 (QE3) was actually lesser than the average being 5.58% indicating that the moves into QE compressed ERPs. Beyond that, I agree with what you spoke on Bloomberg TV in an interview which indicated that equities have largely been pushed up by Wall Street analysts over the last few years which justifies overshooting fundamentals. Coupling both tells me that it's not just risk premiums were low post QE but also that they weren't a consideration for a trader driven market - implying that risk premiums were relatively low (higher highs in asset prices generated by analysts) but on an absolute basis stubbornly high as you mentioned.
The above may or may not be true but is just my interpretation.
Thank you Professor.
Thank you for this excellent article. Another interesting question would be how much lower the ECB can push interest rates. If the interest rates are very negative, please will take Cash out of the bank accounts and put the money in there cushions.
ReplyDeleteBig insurance companies such as Munich Re in Germany are already hording gold and cash in order to avoid the negative interest:
http://www.sueddeutsche.de/wirtschaft/munich-re-rueckversicherer-bunkert-gold-in-geheimem-tresor-1.2909890
An excellent article! But there is one fundamental issue that I have been grappling with over the past few days. There has been so much talk about natural real interest rates being negative over various periods in history (including the post 2008 crisis period). But I somehow am not able to understand the concept of a negative real/natural interest rate. To my mind, it should not be possible. In a world devoid of currencies, it is equivalent to, say, lending 10 bushels of wheat to receive 9 bushels after one year. Even with the costs of storage, I feel it is simply not compatible with human behaviour (which is the trigger for all economic activities).
ReplyDeleteI would be glad to hear your views on this!
I am an Adjunct Faculty at the Singapore Management University. I teach a Global Macro curse for Students of Wealth Management Programme (Master's; one-year). We have had detailed discussions on the global crisis, negative rates, etc. in the last few days. I wanted to provide them more references. The piece by Kevin Warsh and Michael Spence last October and then your blog post in March this year came to mind. I had also blogged on your post in March itself. Just in case you are curious, here is the link:
ReplyDeletehttps://thegoldstandardsite.wordpress.com/2016/03/15/aswath-damodaran-on-negative-rates/
Today, Bank of England cut rates to 0.25% and promised to bring it close to zero in future.
Hi Professor,
ReplyDeleteI am working in a valuation team in HK. Thanks for your sharing.
I understand negative interest rate will not do impact a lot in valuing equity at this moment given the discount rate would include market risk premium and other adjustments. However, I would like to know if we are valuing a bond, say a USD or JPY denominated bond with 5-10 year tenor with AAA credit rating, what kind of discount rate should I use if there is a negative interest rate for corporate bonds with similar rating?
Thanks a lot!
Dear Professor,
ReplyDeleteI have a question about the components of interest rate. What you have said in your paper is that the intrinsic value of interest rate includes the expected inflation, the default risk premium and the real interest rate. However, what I studied in corporate finance about the term structure of interest rate, it said that the interest rate has 1 more component: the interest rate risk premium, which means comparing the 10-year treasury bond and 1-year treasury bond, the change in interest rate will affected the price of 10-year treasury bond more than 1-year treasury bond. The investor, then, requires a premium for the uncertainty of the 10-year bond. When I tried to match 2 source of information together, I was confused how should I understand the interest rate risk premium, should it be included in the intrinsic value of interest rate.
Thanks Professor
Charlie