For clarification, ZIRP refers to a central bank’s policy of setting their short term interest rates at 0 to 25 basis points. It represents one of a central bank’s strongest tools to spur economic activity, and is reserved for extreme circumstances, e.g., The Great Depression, Great Recession, and this Coronavirus shutdown in 2020. For a greater explanation, follow this link (https://www.investopedia.com/articles/investing/031815/what-zero-interestrate-policy-zirp.asp)
With that said, what does this policy mean in 2020 in terms of leverage?:
Firstly, as with any reduction in interest rate, it is supposed to incentivize borrowing and investments on the part of business and consumers. It means that we are going to be taking out more debt (consumers, businesses, and governments alike), since it is going to be much cheaper than in previous years. To this point, I think it would be prudent to take a look at the debt outstanding in the United States. Currently, the total public debt to US GDP ratio stands in excess of 106%, which represents historic highs (https://fred.stlouisfed.org/series/GFDEGDQ188S). In addition, the private debt to GDP ratio stands at almost at 197%, which although is high, is not in the range of the highs in the Great Recession. Look for both these numbers to rise so long as we have ZIRP, and with this $2 Trillion stimulus package that was just passed by the federal government. A more leveraged economy, in my view, is dangerous once it becomes overloaded. Debtors suffer and that carries over to creditors, who are now unable to make money on their investments. The extent to which the Fed carries out ZIRP will tell us how much more leveraged our economy will become.
What caused ZIRP to come back and will it be effective?:
With the Coronavirus situation, it is something unprecedented in our country’s history. What you typically find is that economic downturns are a result of slowing demand, but in this case it is a shutdown on the supply side. Thousands (or millions) of businesses are unable to work at full capacity, unemployment claims reached all time highs, and we are poised for negative GDP growth in Q2 of 2020. This is an extremely serious economic condition (besides the very obvious health issues that take top priority) that requires both a fiscal and monetary response, unless we want the possibility of something like the 1930’s. However, is monetary policy really capable of turning us around?
Monetary policy in the United States and across the world has been extremely dovish. The ECB and BOJ have been using ZIRP (actually going further with negative rates) and in the United States we have been at relatively low rates for the past decade plus. This is significant because the hundred and fifty basis point drop that we had very recently is not some incredible figure. For context, the Fed Fund Rate was cut five hundred basis points to combat the Great Recession in 2008. What this shows, in my estimation, is that the monetary response will not be as effective as it was a decade ago, and fiscal stimulus will have to pick up a lot of the slack.
I think we even have a lot of evidence that the monetary response will not be as effective. In the days after the Fed has made their announcements regarding ZIRP, and even stronger QE measures, the stock market has failed to pick up much momentum. For example, when the Fed made the announcement on Sunday, March 15th, the S&P 500 and the Dow Jones fell substantially the following day.
Impact on Bonds and Equities:
Something very important to consider is the type of investments that low interest rates incentivize, and that is non-debt investments such as stocks. It makes less sense to tie one’s money to fixed income, when yields will be so low, and real yields might even be negative, as 10 Year Treasuries are as of today (3/28/20). I mean if you already had bonds then this could be a good move at least in the short term, since the value of outstanding bonds with a higher nominal interest rate will see their prices rise, but for newly issued bonds, that might not be the case.
On the other hand, with stocks, it is well noted that a drop in interest rates will increase the present value of companies by lowering the value by which their future cash flows are discounted, given that the cost of debt will drop and risk-free rate will change. Could it be a once in a lifetime buying opportunity? Perhaps. Yet could we soon see again a market that is heavily overpriced, with reduced future returns fueled by lower interest rates, yes. Only time will tell what happens, but it should be a tremendous experience. Personally, after taking a look at the work that the people at Bridgewater have produced regarding “Paradigm Shifts”, observing this next decade and analyzing how it differs from the 2010’s should prove to be a great learning experience.
Risks/Further Impact of ZIRP:
- Liquidity Trap
A liquidity trap is defined as when low interest rates are paired with a population who prefers to save their money, rather than spending that money or investing it in higher yielding investments. This is a risk in that a liquidity trap would essentially mean that monetary policy won’t be able to have as great of an impact on stimulating the economy. Japan could be a prime example of this, and is a worthwhile example to examine at a future time.
2. Lending from Banks
Something to consider when looking at the impact of ZIRP is how that affects banks. A bank, in order to properly operate, must choose where it allocates its capital. Whether it be holding it as excess reserve with the Fed and receiving interest on that, or investing it in treasuries, giving out loans to other banks, etc. Historically, when rates have been higher, the opportunity cost of not lending out that money and earning interest was too great. Hence, that explains why banks often had little to no excess reserves with the Fed for a long time (Reference: https://fred.stlouisfed.org/series/EXCSRESNS). However, when rates are pushed so low, and with the Fed paying interest on all reserves (since late 2008), it makes more sense that banks put more into their reserves. This has been the case since 2008, when we previously saw ZIRP. I think this could be a negative in two ways. For one, if the banks are raising their excess reserves, then that symbolizes money that is not being added to the money supply via their power as the fractional banking system. If the intent is to inject liquidity into the market, then this low interest rate policy could be backfiring in this way. Another possible risk is that of higher levels of inflation. Since banks hold such an incredible amount of cash on reserve, they could now theoretically have a lot of power to inadvertently cause greater levels of inflation in the future when they do decide to take it out of their reserves. These are just some things to consider, and we will see how they play out.
Well, this is all I have for now. I will make sure to provide updates on this once I get a better understanding of this matter, and as we see more real world impact in the near future.
