Is monetary policy still effective when central banks take rates below zero?
Or does the very fact that central bankers are taking rates beyond what was previously perceived as their lower bound simply underscore the fact that monetary policy is losing traction and no longer effective?
That’s the question traders and investors are increasingly asking.
It’s also the question Australia’s treasury secretary, John Fraser, said he can’t answer either.
Delivering the lunchtime address at the ASIC annual forum today Fraser said “there has been an active debate about whether monetary policy has reached the limits of its effectiveness in the major advanced economies, particularly its ability to support growth”.
That’s partly why the grand market funk of January and early February 2016 occurred. Traders and investors worried that with growth forecasts being lowered again central banks were beyond the limits of their powers.
More worryingly though Fraser said the post-GFC monetary environment is somewhat speculative:
We have been in this experimental stage with monetary policy for more than seven years now. A range of different interventions have been tried with, at least to date, mixed results.
Sadly we will have to await the passage of years before we can pass final judgment.
Which is where the speculative nature of these policies is dangerous, Fraser said.
What is clear, however, is that unconventional monetary policies have had a pervasive and frankly quite worrying impact on the pricing of financial risk.
In this environment, companies that would historically have been viewed as having too much risk around their cash flows to support large amounts of debt on their balance sheets have been able to issue debt in large volume relatively cheaply, often without covenants.
And those that would historically have been limited to relatively short-term issuance have been able to raise funds at a very long tenor.
Again this is part of the issue that markets have had to deal with in 2016 and why there was an overreaction to the Fed’s initial rate hike in December 2015 and signals about four more hikes in 2016.
Put simply, traders and investors know that like a rising tide low interest rates and other experimental monetary tactics have covered a myriad of company, market, and national sins. So with the tide about to flow out – read higher US interest rates – the risk was companies, countries, and emerging markets in particular were going to be exposed.
We’d know who was swimming naked.
Which is why, as Fraser put it, “markets are increasingly questioning whether global growth will be sufficient to drive corporate earnings and maintain the low default rates necessary to sustain current financial valuations”.