By Philip Cross, July 9, 2015
The Canadian and U.S. economy’s unexpected weakness early in 2015 is fanning speculation about lower interest rates, after the Bank of Canada’s surprise cut in mid-January. Before listening to these siren calls for ever more monetary policy stimulus, it would be wise to read the recent annual report of the Bank for International Settlements, the Swiss-based bank for the world’s central banks. Beholden to no government, the BIS speaks with a refreshingly candid, clear and unconventional voice.
The BIS report openly questions the whole underpinning of the ultra-easy monetary policies central banks around the world are pursuing, including the Bank of Canada. About record low interest rates, it concludes that “there is something deeply troubling when the unthinkable threatens to become routine.”For example, early this year $2 trillion of government debt had negative interest rates (mostly European debt). Low interest rates encourage growth in the short-term, but excessive debt levels dampen growth over the longer term, ultimately putting more downward pressure on interest rates.
Central banks are trapped on the treadmill of the “quick fix” of low interest rates because of their fixation with short-term movements in output and inflation. As a result, policymakers downplay slower-moving financial cycles which can become the dominant economic force, as occurred in 2008. While chronically low interest rates generate diminishing returns for short-term growth, they increase the risks from financial cycles over the medium term. These include speculative rises in asset prices in the stock, bond and housing markets. Low interest rates created financial imbalances that “have sapped productivity and misallocated real resources across sectors and over time.”Slow growth in turn increases the vulnerability to future financial system shocks.
Why are central banks steadfastly pursuing risky policies of ultra-low interest rates? Discounting the idea of a savings glut, the BIS cites an over-reliance on conventional measures of inflation to judge the slack in an economy (‘the output gap”) and excessive fear of deflation. Inflation measures like the Consumer Price Index don’t capture soaring asset market prices that often accompany low inflation. As well, the BIS noted that inflation’s recent slowdown reflects a supply-driven decline in oil prices, not slackening global demand. The current policy debate exaggerates the risk of deflation based uniquely on the 1930s experience, while the BIS finds “the link between deflation and growth is a weak one.” The excessive reliance on lower exchange rates to prevent deflation leads to competitive devaluations between countries and the transmission of easy monetary policy around the globe.
The result is market interest rates persistently below their equilibrium level. The proof is not in conventional measures of inflation and the output gap, which suggest interest rates are not low enough,but rising prices of financial and housing assets, which imply rates are too low. Lower interest rates“cause pervasive mispricing in financial markets” that encourage financial imbalances such as the financial boom whose bust in 2008 has depressed growth for years after. “This also means that interest rates are low today, at least in part, because they were too low in the past. Low rates beget still lower interest rates,” giving policymaking a Groundhog Day aura.
Policymakers are urged to ditch the “faulty debt-fuelled global growth model” of fine-tuning economic growth based on the output gap and replace it with prudent fiscal and monetary policies that aim to boost long-term productivity as well as shoring up the financial position of pension funds and life insurance companies as the population ages. It warns countries like Greece of the risks of “reliance on debt as a substitute for productivity-enhancing reforms” while ignoring the drag high public debt exerts on growth.
The BIS admonishes that “financial factors still appear to be hovering at the periphery of macroeconomic thinking” because of the emphasis on short-term changes in output and inflation. The BIS urges moving financial considerations to the forefront of policymaking, on a par with inflation targets. The recent nosedive in China’s stock market (wiping-out over $2 trillion of wealth) and the insolvency of the Greek banking system are vivid reminders of the importance of financial developments.
Despite its deep knowledge of the international economic and financial system, the BIS report concludes by warning there is “great uncertainty about how the economy works.” In particular, the foundations of models of the economy employed by major central banks are built on quicksand that “harks back to the pre-crisis way of doing things.” By applying the wrong model of the economy, “paradoxically, an easing bias in the short term may end up being contractionary longer-term.” Despite the possible cost of normalizing interest rates, they pale by comparison with the potential fall-out from another epic bust in the financial sector.
Seen from this light, the damage potentially caused by the Bank of Canada’s mid-January rate cut would be compounded by another drop in response to a transitory 0.1 per cent dip in GDP, a clear example of what the BIS calls “the tyranny of headline growth figures” (U.S. GDP too shrank 0.1 per cent, reflecting record cold weather that also affected Eastern Canada and the west coast dock strike).
The BIS view is enlightening, in juxtaposition with recent actions by Bank of Canada Governor Steve Poloz. He’s a protégé of William White, former Deputy Governor of the Bank of Canada and BIS head economist whose views on the risks of ultra-easy monetary policy pervades this report, along with those of current BIS head economist Hyun Sang Shin. Has the Bank overreacted to short-term blips in the economy, forgetting the importance of focusing on longer-term issues? Will it do so again at next week’s policy meeting in response to recent turbulence? Perhaps a calmer view will carry the day.
Philip Cross is a Senior Fellow at the Macdonald-Laurier Institute.