Zero interest rates, heavy debt will be new normal in coronavirus recovery

The lessons learned from the 2008 global financial crisis suggest shutting off the liquidity tap could prove more challenging than opening it
Ultra-accommodative monetary policy is here to stay, with central banks also engaging in riskier asset purchases and even negative interest rates

Aidan Yao

Published: 10:00pm, 15 Jul 2020

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The Covid-19 pandemic has exposed several fault lines in the world that existed before the crisis struck. The widening income gap between rich and poor, the rising political divide between the incumbent leader and rising power, and the enduring wedge between the real economy and financial markets, have all been exacerbated by this once-in-a-generation public health crisis.

Amid the immense shock, central banks have taken unprecedented steps to prevent the global economy from collapsing into another depression. Their actions have resulted in a paradigm shift in the management of monetary policy.

This has manifested in a rapid expansion of central bank balance sheets that contain a wider variety of assets, monetising fiscal deficit, which allows governments to target liquidity injections, and a more audacious intervention in market forces that enables central banks to not just set the price of money but also influence the value of credit, equities and other risky assets.

Central banks have defended these actions as necessary responses to the unprecedented economic shock and vow to withdraw them once the crisis is over. Just like the quantitative easing enacted after the 2008 global financial crisis, though, shutting off the liquidity tap could prove more challenging than opening it, for several reasons.

First, the global economy remains in the doldrums despite the recent improvement in sequential growth. While the current exit from economic lockdown will spur a mechanical rebound in the second half of this year, most economies will not revert to their pre-crisis levels until well into 2021.

This projection is also predicated on the coronavirus being a one-off shock, which may prove too optimistic given recent developments in the United States. Prolonged delay in growth resumption could enlarge the output gap, perpetuate economic damage and hold back central bank policy normalisation.

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Second, the inflation outlook is just as murky. Monetarists posit that “inflation is always and everywhere a monetary phenomenon” and could therefore be rightly concerned about the current policy laxity’s consequences for inflation. In reality, however, such concerns were unfounded in the decade of near-zero interest rates and swollen central bank balance sheets after the global financial crisis.

Even if inflation does make a comeback, the US Federal Reserve has already signalled its willingness to tolerate price increases above the midpoint of its target band after inflation has undershot the target for so long. Hence, without sustained inflation, central banks may find it difficult to justify an exit from current policy settings.

Third, a dramatic increase in debt is likely to cap any interest rate rise. One of the few known consequences of the current crisis is an explosion of debt as a result of the unprecedented stimuli. Fiscal debt ratios of developed countries may surge towards 200 per cent or even 300 per cent of GDP, while private sector leverage will be elevated by the emergency borrowing that kept businesses alive through tough times.

With a mountain of debt, even a small increase in interest rates could derail the global economy’s fragile recovery. Knowing the danger of premature policy withdrawal, few central banks will be willing to risk an economic double dip in the pursuit of policy normalisation.

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Finally, akin to their aversion to renewed economic weakness, no central bank will want to be held responsible for crashing the market. Given how much liquidity has helped fuel market euphoria since the start of quantitative easing, though, it is hard to imagine how asset prices will not take a beating when that liquidity is withdrawn. Moreover, with central banks now the largest holders of many risky assets, any actions that could cause a market meltdown must be weighed carefully against potential damage to their own balance sheets.

In short, it’s highly likely that ultra-accommodative monetary policy is here to stay. Not only are policy rates likely to be nailed to the floor for the foreseeable future, more innovative tools – such as riskier asset purchases, yield-curve controls and even negative interest rates – could be introduced if the current stimulus is insufficient to keep the economy afloat.

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Zero or near-zero interest rates are likely to be a new fact of life in the global monetary environment. All investors need to adapt to this new paradigm.

This could make the lives of those who have fixed-return liabilities more difficult, but benefit those who lean toward assets that generate constant cash flows, which will be discounted at low or even negative real interest rates. A fundamental change in how investors view, price and allocate risks will be needed as the world moves toward Japanese-style zero interest rates.

Aidan Yao is senior emerging Asia economist at AXA Investment Managers

This article appeared in the South China Morning Post print edition as: Zero interest rates, heavy debt will be normal after Covid-19

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