It is now some seven years since the financial crisis and nearly seven years since interest rates in the USA, the eurozone, the UK and elsewhere have been close to zero. But have these record low interest rates and the bouts of quantitative easing that have accompanied them resulted in higher or lower investment than would otherwise have been the case? There has been a big argument about that recently.
According to conventional economic theory, investment is inversely related to the rate of interest: the lower the rate of interest, the higher the level of investment. In other words, the demand-for-investment curve is downward sloping with respect to the rate of interest. It is true that in recent years investment has been low, but that, according to traditional theory, is the result of a leftward shift in demand thanks to low confidence, not to quantitative easing and low interest rates.
In a recent article, however, Michael Spence (of New York University and a 2001 Nobel Laureate) and Kevin Warsh (of Stanford University and a former Fed governor) challenge this conventional wisdom. 
According to them, QE and the accompanying low interest rates led to a rise in asset prices, including shares and property, rather than to investment in the real economy. The reasons, they argue, are that investors have seen good short-term returns on financial assets but much greater uncertainty over investment in physical capital. Returns to investment in physical capital tend to be much longer term; and in the post-financial crisis era, the long term is much less certain, especially if the Fed and other central banks start to raise interest rates again.
“We believe that QE has redirected capital from the real domestic economy to financial assets at home and abroad. In this environment, it is hard to criticize companies that choose ‘shareholder friendly’ share buybacks over investment in a new factory. But public policy shouldn’t bias investments to paper assets over investments in the real economy.”
This analysis has been challenged by several eminent economists, including Larry Summers, Harvard Economics professor and former Treasury Secretary. He criticises them for confusing correlation (low investment coinciding with low interest rates) with causation. As Summers states:
“This is a little like discovering a positive correlation between oncologists and cancer and asserting that this proves oncologists cause cancer. One would expect in a weak recovery that investment would be weak and monetary policy easy. Correlation does not prove causation. …If, as Spence and Warsh assert, QE has raised stock prices, this should tilt the balance toward real investment.”
Not surprisingly Spence and Warsh have an answer to this criticism. They maintain that their critique is less of low interest rates but rather of the form that QE has taken, which has directed new money into the purchase of financial assets. This then has driven further asset purchases, much of it by companies, despite high price/earnings ratios (i.e. high share prices relative to dividends). As they say:
“Economic theory might have something to learn from recent empirical data, and from promising new thinking in behavioral economics.”
Study the arguments of both sides and try to assess their validity, both theoretically and in the light of evidence.
Articles
The Fed Has Hurt Business Investment The Wall Street Journal, Michael Spence and Kevin Warsh (26/10/15) [Note: if you can’t see the full article, try clearing cookies (Ctrl+Shift+Delete)]
I just read the ‘most confused’ critique of the Fed this yea Washington Past, Lawrence H. Summers (28/10/15)
A Little Humility, Please, Mr. Summers The Wall Street Journal, Michael Spence and Kevin Warsh (4/11/15) [Note: if you can’t see the full article, try clearing cookies (Ctrl+Shift+Delete)]
Do ultra-low interest rates really damage growth? The Economist (12/11/15)
It’s the Zero Bound Yield Curve, Stupid! Janus Capital, William H Gross (3/11/15)
Is QE Bad for Business Investment? No Way! RealTime Economic Issues Watch, Joseph E. Gagnon (28/10/15)
Department of “Huh!?!?”: QE Has Retarded Business Investment!? Washington Center for Equitable Growth, Brad DeLong (27/10/15)
LARRY SUMMERS: The Wall Street Journal published the ‘single most confused analysis’ of the Fed I’ve read this year Business Insider, Myles Udland (29/10/15)
The Fed’s Loose Money, Financial Markets and Business Investment SBE Council, Raymond J. Keating (29/10/15)
How the QE trillions missed their mark AFR Weekend, Maximilian Walsh (4/11/15)
Financial Markets In The Era Of Bubble Finance – Irreversibly Broken And Dysfunctional David Stockman’s Contra Corner, Doug Noland (8/11/15)
Questions
- Go through the arguments of Spence and Warsh and explain them.
- Explain what are meant by the ‘yield curve’ and ‘zero bound yield curve’.
- What criticisms of their arguments are made by Summers and others?
- Apart from the effects of QE, why else have long-term interest rates been low?
- In the light of the arguments on both sides, how effective do you feel that QE has been?
- How could QE have been made more effective?
- What is likely to happen to financial markets over the coming months? What effect is this likely to have on the real economy?
Mario Draghi, the ECB President, has indicated that the ECB is prepared to engage in further monetary stimulus. This is because of continuing weaknesses in the global economy and in particular in emerging markets.
Although the ECB at its meeting in Malta on 22 October decided to keep both interest rates and asset purchases (€60 billion per month) at current levels, Mario Draghi stated at the press conference that, at its next meeting on December 3rd, the ECB would be prepared to cut interest rates and re-examine the size, composition and duration of its quantitative easing programme. He stopped short, however, of saying that interest rates would definitely be cut or quantitative easing definitely increased. He said the following:
“The Governing Council has been closely monitoring incoming information since our meeting in early September. While euro area domestic demand remains resilient, concerns over growth prospects in emerging markets and possible repercussions for the economy from developments in financial and commodity markets continue to signal downside risks to the outlook for growth and inflation. Most notably, the strength and persistence of the factors that are currently 
slowing the return of inflation to levels below, but close to, 2% in the medium term require thorough analysis.
In this context, the degree of monetary policy accommodation will need to be re-examined at our December monetary policy meeting, when the new Eurosystem staff macroeconomic projections will be available. The Governing Council is willing and able to act by using all the instruments available within its mandate if warranted in order to maintain an appropriate degree of monetary accommodation.”
Mario Draghi also argued that monetary policy should be supported by fiscal policy and structural policies (mirroring Japan’s three arrows). Structural policies should include actions to improve the business environment, including the provision of an adequate public infrastructure. This is vital to “increase productive investment, boost job creation and raise productivity”.
As far as fiscal policies are concerned, these “should support the economic recovery, while remaining in compliance with the EU’s fiscal rules”. In other words, fiscal policy should be expansionary, while staying within the limits set by the Stability and Growth Pact.
His words had immediate effects in markets. Eurozone government bond yields dropped to record lows and the euro depreciated 3% against the US dollar over the following 24 hours.
Webcasts
ECB Press Conference on YouTube, Mario Draghi (22/10/15)
Draghi reloads bazooka FT Markets, Ferdinando Guigliano (22/10/15)
Articles
Mario Draghi: ECB prepared to cut interest rates and expand QE The Guardian, Heather Stewart (22/10/15)
Draghi signals ECB ready to extend QE Financial Times, Claire Jones and Elaine Moore (22/10/15)
Dovish Mario Draghi sends bond yields to new lows Financial Times, Katie Martin (23/10/15)
What Draghi Said on QE, Policy Outlook, Global Risks and Inflation Bloomberg, Deborah Hyde (22/10/15)
ECB set to ‘re-examine’ stimulus policy at next meeting BBC News (22/10/15)
The global economy warrants a big dose of caution The Guardian, Larry Elliott (25/10/15)
ECB Press Conference
Introductory statement to the press conference (with Q&A) ECB, Mario Draghi (President of the ECB), Vítor Constâncio (Vice-President of the ECB) (22/10/15)
Questions
- Why is the ECB considering further expansionary monetary policy?
- What monetary measures can a central bank use to stimulate aggregate demand?
- Explain the effects of Mario Draghi’s announcement on bond and foreign exchange markets.
- What are the objectives of ECB monetary policy according to the its mandate?
- Should the ECB consider using quantitative easing to provide direct funding for infrastructure projects?
- What constraints does the EU’s Stability and Growth Pact impose on eurozone countries?
- What are the arguments for and against (a) the Bank of England and (b) the US Federal Reserve engaging in further QE?
- If the ECB does engage in an expanded QE programme, what will determine its effectiveness?
Over 2015 quarter 3, stock markets around the world have seen their biggest falls for four years. As the BBC article states: ‘the numbers for the major markets from July to September make for sobering reading’.
• US Dow Jones: –7.9%
• UK FTSE 100: –7.04%
• Germany Dax: –11.74%
• Japan Nikkei: –14.47%
• Shanghai Composite: –24.69%
So can these falls be fully explained by the underlying economic situation or is there an element of over-correction, driven by pessimism? And, if so, will markets bounce back somewhat? Indeed, from 30 September to 2 October, markets did experience a rally. For example, the FTSE 100 rose from a low of 5877 on 29 September to close at 6130 on 3 October (a rise of 4.3%). But is this what is known as a ‘dead cat bounce’, which will see markets fall back again as pessimism once more takes hold?
As far as the global economic scenario is concerned, things have definitely darkened in the past few months. As Christine Lagarde, Managing Director of the IMF, said in an address in Washington ahead of the release of the IMF’s 6-monthly, World Economic Outlook:
I am concerned about the state of global affairs. The refugee influx into Europe is the latest symptom of sharp political and economic tensions 
in North Africa and the Middle East. While this refugee crisis captures media attention in the advanced economies, it is by no means an isolated event. Conflicts are raging in many other parts of the world, too, and there are close to 60 million displaced people worldwide.
Let us also not forget that the year 2015 is on course to be the hottest year on record, with an extremely strong El Niño that has spawned weather-related calamities in the Pacific.
On the economic front, there is also reason to be concerned. The prospect of rising interest rates in the United States and China’s slowdown are contributing to uncertainty and higher market volatility. There has been a sharp deceleration in the growth of global trade. And the rapid drop in commodity prices is posing problems for resource-based economies.
Words such as these are bound to fuel an atmosphere of pessimism. Emerging economies are expected to see slowing economic growth for the fifth year in succession. 
And financial stability is still not yet assured despite efforts to repair balance sheets following the financial crash of 2008/9.
But as far as stock markets are concerned, the ECB is in the process of a massive quantitative easing programme, which will boost asset prices, and Japan looks as if it too will embark on a further round of QE. Interest rates remain very low, and, as we discussed in the blog Down down deeper and down, or a new Status Quo?, some central banks now have negative rates of interest. This makes shares relatively attractive for savers, so long as it is believed that they will rise over the medium term.
Then there is the question of speculation. The falls were partly due to people anticipating that share prices would fall. But has this led to overshooting, with prices set to rise again? Or, will pessimism set in once more as people become even gloomier about the world economy? If only I had a crystal ball!
Articles
Markets see their worst quarter in four years BBC News (1/10/15)
Weak Jobs Data Can’t Keep U.S. Stocks Down Wall Street Journal, Corrie Driebusch (2/10/15)
What the 3rd Quarter Tells Us About The Stock Market In October EFT Trends, Gary Gordon (2/10/15)
The bull market ahead: Why shares should make 6.7pc a year until 2025 The Telegraph, Kyle Caldwell (5/9/15)
Is the FTSE 100’s six year run at an end? The bull and bear points The Telegraph, Kyle Caldwell (24/8/15)
Webcasts
The stock market bull may not be dead yet CNNMoney (29/9/15)
IMF’s Lagarde: More volatility likely for emerging markets CNBC, Everett Rosenfeld (30/9/15)
What’s next for stocks after worst quarter in four year CNBC, Patti Domm (30/9/15)
Global markets to log worst quarter since 2011 CNBC, Nyshka Chandran (30/9/15)
Speech
Managing the Transition to a Healthier Global Economy IMF, Christine Lagarde (30/9/15)
Questions
- Distinguish between stabilising and destabilising speculation. Is it typical over a period of time that you will get both? Explain.
- What is meant by a ‘dead cat bounce’? How would you set about identifying whether a given rally was such a phenomenon?
- Examine the relationship between the state (and anticipated state) of the global economy and share prices.
- What is meant by (a) the dividend yield on a share; (b) the price/earnings ratio of a share? Investigate what has been happening to dividend yields and price/earnings ratios over the past few months. What is the relationship between dividend yields and share prices?
- Distinguish between bull and bear markets.
- What factors are likely to drive share prices (a) higher; (b) lower?
- Is now the time for investors to buy shares?
If you asked virtually any banker or economist a few years ago whether negative (nominal) interest rates were possible, the answer would almost certainly be no.
Negative real interest rates have been common at many points in time – whenever the rate of inflation exceeds the nominal rate of interest. People’s debts and savings are eroded by inflation as the interest due or earned does not keep pace with rising prices.
But negative nominal rates? Surely this could never happen? It was generally believed that zero (or slightly above zero) nominal rates represented a floor – ‘a zero lower bound’.
The reasoning was that if there were negative nominal rates on borrowing, you would effectively be paid by the bank to borrow.
In such a case, you might as well borrow as much as you can, as you would owe less later and could pocket the difference.
A similar argument was used with savings. If nominal rates were negative, savers might as well withdraw all their savings from bank accounts and hold them as cash (perhaps needing first to buy a safe!) Given, however, that this might be inconvenient and potentially costly, some people may be prepared to pay banks for looking after their savings.
Central bank interest rates have been hovering just above zero since the financial crisis of 2008. And now, some of the rates have turned negative (see chart above). The ECB has three official rates:
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| • |
The interest rate on the main refinancing operations (MRO), which provide the bulk of liquidity to the banking system. |
| • |
The rate on the deposit facility, which banks may use to make overnight deposits with the Eurosystem. |
| • |
The rate on the marginal lending facility, which offers overnight credit to banks from the Eurosystem. |
The first of these is the most important rate and remains above zero – just. Since September 2014, it has been 0.05%. This rate is equivalent to the Bank of England’s Bank Rate (currently still 0.5%) and the Fed’s Federal Funds Rate (currently still between 0% and 0.25%).
The third of the ECB’s rates is currently 0.3%, but the second – the rate on overnight deposits in the ECB by banks in the eurozone – is currently –0.2%. 
In other words, banks have to pay the ECB for making these overnight deposits (deposits that can be continuously rolled over). The idea has been to encourage banks to lend rather than simply keeping unused liquidity.
In Nordic countries, the experiment with negative rates has gone further. With plenty of slack in the Swedish economy, negative inflation and an appreciating krona, the Swedish central bank – the Riksbank – cut its rates below zero.
Many City analysts believe that the Riksbank will continue cutting, reducing its key interest rate to minus 0.5% by the end of the year [it is currently 0.35%]. Switzerland’s is already deeper still, at minus 0.75%, while Denmark and the eurozone have joined them as members of the negative zone.
But the nominal interest rate on holding cash is, by definition, zero. If deposit rates are pushed below zero, then will more and more people hold cash instead? 
The hope is that negative nominal interest rates on bank accounts will encourage people to spend. It might, however, merely encourage them to hoard cash.
The article below from The Telegraph looks at some of the implications of an era of negative rates. The demand for holding cash has been increasing in many countries and, along with it, the supply of banknotes, as the chart in the article shows. Here negative interest are less effective. In Nordic countries, however, the use of cash is virtually disappearing. Here negative interest rates are likely to be more effective in boosting aggregate demand.
Article
How Sweden’s negative interest rates experiment has turned economics on its head The Telegraph, Peter Spence (27/9/15)
Data
Central bank and monetary authority websites Bank for International Settlements
Central banks – summary of current interest rates global-rates.com
Questions
- Distinguish between negative real and negative nominal interest rates.
- What is the opportunity cost of holding cash – the real or the nominal interest rate forgone by not holding it in a bank?
- Are there any dangers of central banks setting negative interest rates?
- Why may negative interest rates be more effective in Sweden than in the UK?
- ‘Andy Haldane, a member of the Monetary Policy Committee (MPC) … suggested that to achieve properly negative rates, the abolition of cash itself might be necessary.’ Why?
- Why does Switzerland have notes of SF1000 and the eurozone of €500? Should the UK have notes of £100 or even £500?
- Why do some banks charge zero interest rates on credit cards for a period of time to people who transfer their balances from another card? Is there any incentive for banks to cut interest rates on credit cards below zero?
Interest rates are the main tool of monetary policy and have a history of being an effective tool in creating macroeconomic stability. There has been much discussion since the end of the financial crisis concerning when interest rates would rise in the US (and the UK) and for the US, the case is stronger, given its rate of growth, which has averaged at 2.2% per annum since June 2009.
As in the UK, the question of ‘will rates rise?’ has a clear and certain answer: Yes. The more challenging question is ‘when?’. Much of the macroeconomic data for the US is promising, with positive economic growth (and relatively strong in comparison to the UK and Eurozone), a low unemployment rate and inflation of 0.3%. This last figure is ‘too low’, but it comes in at a much more attractive 1.2% if you exclude food and energy costs and there is an argument for doing this, given the price of oil. The data on unemployment and growth might suggest that the economy is at a stage where a rate rise could be managed, but the inflation data indicates that low interest rates might be needed to keep inflation above 0%. Furthermore, there are concerns that the low unemployment figure is somewhat misleading, given that under-employment is quite high at 10.3% and there are still many who are long-term unemployed, having been out of work for more than 6 months.
Interest rates can be a powerful tool in affecting the components of aggregate demand (AD) and hence the macroeconomic variables. If interest rates fall, it can help to stimulate AD by reducing borrowing costs for consumers and businesses, reducing the incentive to save, cutting variable rate mortgage payments and depreciating the exchange rate. Collectively these effects can stimulate an economy and hence create economic growth, reduce unemployment and push up prices. However, interest rates have been at almost 0% since the financial crisis, so the only way is up. Reversing the aforementioned effects could then spell trouble, if the economy is not in a sufficiently strong position.
For many, the strength of the US economy, while relatively good, is not yet good enough to justify a rate rise. It may harm investment, growth and unemployment and none of these variables are sufficiently high to warrant a rate rise, especially given the slowdown in the emerging markets. Karishma Vaswani, from BBC News said:
“The current global hand-wringing and head-holding over whether the US Fed will or won’t raise interest rates later has got investors here in Asia worried about what this means for their economies.
The Fed has become the favourite whipping boy of Asia’s central bankers, with cries from India to Indonesia to “just get on with it”.”
There are many, including Professor John Taylor from Stanford University and a former senior Treasury official, a rate rise is well over-due. The market is expecting one and has been for some time and these expectations aren’t going away, so ‘just get on with it.’ Janet Yellen, the Chair of the Federal Reserve is in a tricky situation. She knows that whatever is decided, markets around the world will react – no pressure then! The following articles consider the interest rate debate.
Articles
FTSE slides ahead of Fed interest rates decision The Telegraph, Tara Cunningham (17/9/15)
US’s interest rate rise dilemma BBC News, Andrew Walker (17/9/15)
US interest rate rise: how it could affect your savings and your mortgage Independent (17/9/15)
All eyes on Federal Reserve as it prepares for interest rate announcement The Guardian, Rupert Neate (16/9/15)
Federal Reserve meeting: Will US interest rates rise and should they? The Telegraph, Peter Spence (16/9/15)
Markets push US rate rise bets into 2016 as China woes keep Fed on hold: as it happened The Telegraph, Szu Ping Chan (17/9/15)
Federal Reserve puts rate rise on hold The Guardian (17/9/15)
US central bank leave interest rates unchanged BBC News (17/5/15)
Fed leaves interest rates unchanged Wall Street Journal, Jon Hilsenrath (17/9/15)
Asian markets mostly rally, US Futures waver ahead of Fed interest rate decision International Business Times, Aditya Tejas (17/9/15)
Data
Selected US interest rates Board of Governors of the Federal Reserve System (see, for example, Federal Funds Effective rate (monthly))
Questions
- What happened to US interest rates in September?
- Present the main arguments for keeping interest rates on hold.
- What were the arguments in favour of raising interest rates and do they differ depending on whether interest rates rise slowly or very rapidly?
- How did stock markets around the world react to Janet Yellen’s announcement? Is it good news for the UK?
- Using a diagram to support your explanation, outline why interest rates are such a powerful tool of monetary policy and how they affect the main macroeconomic objectives.
- Do you think other central banks will take note of the Fed’s decision, when they make their interest rate decisions in the coming months? Explain your answer.
It is now some seven years since the financial crisis and nearly seven years since interest rates in the USA, the eurozone, the UK and elsewhere have been close to zero. But have these record low interest rates and the bouts of quantitative easing that have accompanied them resulted in higher or lower investment than would otherwise have been the case? There has been a big argument about that recently.
According to them, QE and the accompanying low interest rates led to a rise in asset prices, including shares and property, rather than to investment in the real economy. The reasons, they argue, are that investors have seen good short-term returns on financial assets but much greater uncertainty over investment in physical capital. Returns to investment in physical capital tend to be much longer term; and in the post-financial crisis era, the long term is much less certain, especially if the Fed and other central banks start to raise interest rates again.
