Low rates, different risks

The last week has provided clear evidence of the financial market benefit of aggressive monetary stimulus. Equities have rallied. Bond yields are low. Assets across the board have performed well.

The scale of policy stimulus across the world is considerable. In recent years it was mainly focused on monetary policy, highlighted by very low policy rates. Now, monetary stimulus has been taken even further, particularly in Japan and the European Union, and even now in the UK as we saw recently with the Bank of England. The advanced economies are leading the way. The US, too, despite evidence of the jobs market there proving resilient, is persisting with low rates, reluctant to tighten in case it may do so prematurely.

Although we have become used to low interest rates, it would be wrong to underplay what is now happening. The scale of current monetary stimulus is now huge. Bond yields are in negative territory in many countries. The balance sheets of the major central banks have ballooned.

Not only that, but across emerging economies there is also the option of further monetary stimulus to come, if countries so chose. I have said before that China, too, could opt yet to push rates towards zero.

Just as importantly, in addition to all this, fiscal policy is now being used more openly and actively as a policy boost. Earlier this year, Japan in hosting the G7 seemed to make the case for further stimulus, and now Japan appears to be taking the lead, led by PM Abe and the Bank of Japan. Likewise, China in hosting the G20 meeting of Finance Ministers and Central Bank Governors recently, reiterated the case for stimulus. And that is what we are now seeing.

The combination of monetary and fiscal stimulus is now considerable. This is positive for the world economy. And it is helping asset markets too.

From a policy perspective the question that needs to be asked is whether enough reform or supply side change is taking place? The need for such change varies across countries, but in the UK it would be linked to the need to boost productivity. Admittedly the productivity gap with other countries was closing before the financial crisis and since then we have seen sizeable employment growth, alongside the disappointing productivity that has gone with it.

The implication of all this stimulus risks something new happening this autumn. In October the IMF will release their updated economic forecast when they publish the World Economic Outlook. A constant feature for some years now has been the IMF regularly revising down their economic forecasts for the immediate years ahead. This autumn there is the serious possibility that for the first time in years this may not happen! In all likelihood the IMF will retain its projection of steady growth; and perhaps even become more positive. This would be good news.

Therein lies a challenge. For now it seems the focus for policymakers and many in the markets is largely on achieving stronger economic growth. But the flip side of the pro-growth policy stimulus that we are now seeing is creating some significant risks.

Markets have become overly dependent upon low rates. As Japan has shown, once engrained it then becomes hard to change and to tighten policy. But keeping rates low feeds many unintended consequences.

For instance, low yields compound funding problems for pension funds. They hit savers, perhaps forcing them to take unnecessary investment risks and also push asset prices higher. This can add to inequality in society.

It raises the question as to what now constitutes a risk free asset and what is a safe investment? Are government bonds and property really as safe an investment as the financial system thinks they are? With low interest rates, markets are not incentivised to price properly for risk.

Ahead of the 2007-08 crisis, one issue was that of crowded trades. Many investors were doing the same thing in the expectation of being able to get out just in time. This becomes less of a concern in highly liquid markets, but when yields are low it still means that swings in sentiment or changes in economic conditions can cause abrupt market movements.

For now though, volatility measures have fallen sharply as well. This suggests markets are not expecting any monetary shocks for now. That is likely to be right. But now, even more than ever, it puts the emphasis on anticipating future economic conditions and how this will impact economic conditions, policy decisions and market behaviour.

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