(Aug 19): The widely expected 25-basis-point rate cut by the US Federal Reserve last month pretty much confirmed that low interest rates are here to stay. The cut in the benchmark federal funds rate to a range of 2% to 2.25% is the first since December 2008.
While the cut was lower than the 50bps that many had predicted, it came after three successive raises in interest rates since last December.
Central banks around the world are following suit. Bank Negara Malaysia reduced its overnight policy rate in May. More recently, shortly after the Fed announced its rate cut, the Reserve Bank of New Zealand shocked many by slashing its official cash rate by 50bps to 1%.
Such cuts in recent times are a response to fears of a more pronounced global slowdown, says United Overseas Bank (M) senior economist Julia Goh.
Lee Heng Guie, executive director of KL-based Socio-Economic Research Centre (SERC), concurs. “With the heightening global economic uncertainties due to the elevated trade tensions, we expect global interest rates to stay low — at least over the next 12 months — to provide insurance against any unattended risks that would undermine the global economy,” he tells The Edge Malaysia.
The concern, he adds, is that “a severe enough shock could usher in a sharp economic slowdown or even a recession risk in the US economy”.
UOB’s Goh nevertheless expects interest rates to stay lower for longer even in the absence of any severe shock, partly due to structural shifts — such as low inflation, slower productivity and an older population — that are affecting mostly advanced economies.
A decade-old cultivated addiction
It is arguable that the global economy is “addicted” to low interest rates, having had them for over a decade. They have helped lower the cost of funds, making borrowing cheap, which is meant to stimulate demand and lower the hurdles for investments.
They have also helped economies around the world recover from the global financial crisis of 2008/09 and kept the US in its longest period of economic growth.
SERC’s Lee says investors in both financial markets and households are addicted to low interest rates because they spur consumption and investment — debt-fuelled and risk-excessive though they may be, respectively.
He adds that the fragile state of the global economy places immense pressure on central banks to use their monetary arsenal, given the fiscal constraints and high-debt situation of some governments.
“Unfortunately, this time around, monetary policy tools are limited. Interest rates are very low, and it gives the central banks very limited room to cut interest rates.
“Today, the Fed is starting with a benchmark policy rate of 2.25% to 2.5%, compared with 5.25% in September 2007. In Europe and Japan, central banks are already in negative-rate territory and will face limits on how much further below the zero-bound they can go,” says Lee.
Some emerging countries, however, still have the monetary space to lower interest rates, though it might not be necessary for them to use it, notes Yeah Kim Len, economics professor at Sunway University Business School in Subang Jaya, Selangor. “There are other macro policy tools available besides monetary policies, such as fiscal or industrial and trade policies. The decision should be made on which tool is the most effective in driving growth,” he says.
Woes of prolonged monetary expansion
There is no denying that expansionary monetary policy alongside fiscal stimulus has helped to spur economic revival post-global financial crisis, but experts note that it has also created financial imbalances in the form of excessive leveraging by corporates, households and governments. Yeah warns of such consequences of lower interest rates over the medium to long term.
As at end-December last year, global debt stood at 233.7% of world GDP, which exceeded the previous record of 213% in 2009.
Lee observes that the global economic recovery since two decades ago “lacks fundamental and sustainable growth drivers”. He cites as examples, “structural reforms to increase productivity” as well as “quality and productive investment such as infrastructure, education and technology advancement, and human capital formation”.
He adds that the biggest concern with the prolonged low interest rate environment is financial stability, as investors respond to “low-for-long” interest rates by increasing risk-taking activity and undertaking speculative investment without being supported by fundamentals.
“The debt binge and over-leveraging will expose the corporates, households and financial sector to vulnerabilities if there is a severe economic downturn, leading to loss of employment and income, as well as a reversal of low interest rates.
“The issue of financial stability is also closely related to a low interest rate environment, which could result in elevated valuations, asset price bubbles, higher risk-taking and a search for yield. This requires putting a strong macro-prudential framework in place,” says Lee.
The low interest rate environment has also driven up asset prices, and this could continue.
“Key drivers of asset prices are easy access to funds and low cost of funds,” says Sunway University’s Yeah. “The concern is a sharp market correction and the negative effects that [will result] and spill over into the economy.”
While interest rates are set to remain low for an extended period of time, whether we can get out of this situation remains to be seen.
Says Lee, “Looking at post-global financial crisis, the Fed only started to normalise its benchmark interest rate in baby steps by a cumulative 250bps from 2015 to 2018, before cutting rates last month and stopping the unwinding of its balance sheet to safeguard the US economy against the implications of protracted trade tensions. Bank of Japan and the European Central Bank still cannot get out of the negative interest rate environment till today.”
Esther Lee is an assistant editor with the Capital Markets & Companies desk at The Edge Malaysia
