Best of the Week
Most Popular
1. Investing in a Bubble Mania Stock Market Trending Towards Financial Crisis 2.0 CRASH! - 9th Sep 21
2.Tech Stocks Bubble Valuations 2000 vs 2021 - 25th Sep 21
3.Stock Market FOMO Going into Crash Season - 8th Oct 21
4.Stock Market FOMO Hits September Brick Wall - Evergrande China's Lehman's Moment - 22nd Sep 21
5.Crypto Bubble BURSTS! BTC, ETH, XRP CRASH! NiceHash Seizes Funds on Account Halting ALL Withdrawals! - 19th May 21
6.How to Protect Your Self From a Stock Market CRASH / Bear Market? - 14th Oct 21
7.AI Stocks Portfolio Buying and Selling Levels Going Into Market Correction - 11th Oct 21
8.Why Silver Price Could Crash by 20%! - 5th Oct 21
9.Powell: Inflation Might Not Be Transitory, After All - 3rd Oct 21
10.Global Stock Markets Topped 60 Days Before the US Stocks Peaked - 23rd Sep 21
Last 7 days
INVESTING LESSON - Give your Portfolio Some Breathing Space - 4th Dec 21
Don’t Get Yourself Into a Bull Trap With Gold - 4th Dec 21
GOLD HAS LOTS OF POTENTIAL DOWNSIDE - 4th Dec 21
4 Tips To Help You Take Better Care Of Your Personal Finances- 4th Dec 21
What Is A Golden Cross Pattern In Trading? - 4th Dec 21
Bitcoin Price TRIGGER for Accumulating Into Alt Coins for 2022 Price Explosion - Part 2 - 3rd Dec 21
Stock Market Major Turning Point Taking Place - 3rd Dec 21
The Masters of the Universe and Gold - 3rd Dec 21
This simple Stock Market mindset shift could help you make millions - 3rd Dec 21
Will the Glasgow Summit (COP26) Affect Energy Prices? - 3rd Dec 21
Peloton 35% CRASH a Lesson of What Happens When One Over Pays for a Loss Making Growth Stock - 1st Dec 21
Stock Market Sentiment Speaks: I Fear For Retirees For The Next 20 Years - 1st Dec 21 t
Will the Anointed Finanical Experts Get It Wrong Again? - 1st Dec 21
Main Differences Between the UK and Canadian Gaming Markets - 1st Dec 21
Bitcoin Price TRIGGER for Accumulating Into Alt Coins for 2022 Price Explosion - 30th Nov 21
Omicron Covid Wave 4 Impact on Financial Markets - 30th Nov 21
Can You Hear It? That’s the Crowd Booing Gold’s Downturn - 30th Nov 21
Economic and Market Impacts of Omicron Strain Covid 4th Wave - 30th Nov 21
Stock Market Historical Trends Suggest A Strengthening Bullish Trend In December - 30th Nov 21
Crypto Market Analysis: What Trading Will Look Like in 2022 for Novice and Veteran Traders? - 30th Nov 21
Best Stocks for Investing to Profit form the Metaverse and Get Rich - 29th Nov 21
Should You Invest In Real Estate In 2021? - 29th Nov 21
Silver Long-term Trend Analysis - 28th Nov 21
Silver Mining Stocks Fundamentals - 28th Nov 21
Crude Oil Didn’t Like Thanksgiving Turkey This Year - 28th Nov 21
Sheffield First Snow Winter 2021 - Snowballs and Snowmen Fun - 28th Nov 21
Stock Market Investing LESSON - Buying Value - 27th Nov 21
Corsair MP600 NVME M.2 SSD 66% Performance Loss After 6 Months of Use - Benchmark Tests - 27th Nov 21

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

Reversal Interest Rates Are the Next Big Challenge for Central Banks

Interest-Rates / US Interest Rates Nov 22, 2016 - 03:07 AM GMT

By: John_Mauldin

Interest-Rates

BY SAMUEL RINES : Negative and ultra-low interest rates have become the norm for the developed world. The phrases “lower for longer” and “new normal” are now accepted as facts rather than predictions. But, how low is too low?

For many developed world economies, rates remain low in order to combat stagnation as growth slows. Negative rates are a side effect of these deep, fundamental economic issues.


That brings up some big questions: How low? And for how long?

New research by Markus K. Brunnermeier and Yann Koby addresses this issue. They’ve tried to determine the point at which lower policy rates lose their stimulative effect.

Their research shows that lowering interest rates too far can be contractionary instead of stimulative. And the consequences are profound.

How quantitative easing really works

Before the Great Recession, the Fed Funds rate was the Fed’s main way of transmitting monetary policy. The fear then was that holding its policy rate too low for too long would cause inflation pressures to rise dramatically.

But times have changed. Now, the problem is precisely the opposite. The need to provide more stimulus has led to quantitative easing… and eventually to negative interest rates.

The process of quantitative easing is not as esoteric as it sounds. A central bank buys bonds or mortgages, typically from banks. This provides banks with reserves (cash) for assets. Banks then turn around and lend to individuals and businesses at lower interest rates than before. Economic growth ensues.

Individual banks are responsible for transmitting the policy to the economy. This means (as Brunnermeier and Koby point out) that the order of the stimulus matters.

Banks profit from loaning money out and holding bonds. So, when the Fed cuts interest rates, the value of the loans increases, which benefits the bank.

If the Fed decides it needs to conduct QE, the bank is able to sell these loans and bonds to the Fed at elevated prices. This is another benefit for the individual bank.

Eventually, this virtuous cycle ends because banks do not have endless expensive assets to sell to the Fed. This is where the “reversal rate” comes into play.

Why the reversal rate is a big problem

By lowering rates too far, a central bank removes the incentive for banks to lend. Without lending at lower rates, the bank has fewer of the assets to sell to the Fed and more volatile short-term deposits.

This breaks down the transmission of policy and creates a point at which lowering rates actually slows economic growth—the “reversal rate.”

This is why quantitative easing should always follow the lowering of interest rates. Otherwise, the higher asset prices accrue to the central bank, and the stimulus is inconsequential as quantitative easing has run its course.

This theory is not without some irony. Oddly, it negates the notion of negative and ultra-low interest rates being inherently inflationary. In fact, ultra-low rates could be disinflationary.

While the reversal rate has negative economic consequences, this does not affirm the fear expressed by the media that all negative rates are harmful. Negative rates only become harmful when they fall below the reversal rate.

A reversal rate would suggest that monetary policy has less of a margin in which to effectively operate than before. At its latest meeting, the Fed’s dot plot of projections put the “neutral” long-term rate at 2.875%, down from 4.25% at the beginning of 2012.

Assuming the US reversal rate rarely moves and is near zero, the overall monetary policy area is shrinking. In a sense, this means the Fed’s policy range shrank from 4.25% to 2.875%, which causes policy to be more difficult to execute.

In this situation, policy mistakes are more costly because there is not much in the economic toolkit to work with. It also means that quantitative easing may not be as effective as in previous cycles. In essence, if a reversal rate exists, it makes the need for infrastructure development a necessity to stimulate the economy.

The idea of a reversal rate is new. In fact, there has yet to be agreement among economists on whether it exists, and if it does, what it might be for the US. But it makes intuitive sense that there exists a level where stimulus leads to restriction.

Central banks need to rethink the process and policies by which their new unconventional tools are delivered and how long these tools should be maintained. Figuring out how monetary policy can stimulate after reaching the reversal point will prove difficult. Understanding how far is too far, and how long is too long, will be the next great central bank challenge.

Become the Best-Informed Investor You Know

The world is more interconnected than ever before. Only those investors who understand how current world events are linked can prepare for what’s going to happen. Sign up for Mauldin Economics’ free weekly newsletters for a bird’s-eye view of macroeconomic reality.

Samuel Rines is a regular contributor to Mauldin Economics. He is the Senior Economist and Portfolio Strategist at Avalon Advisors in Houston, TX.

John Mauldin Archive

© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in