Conventional wisdom holds that central banks have pushed down interest rates through the buying of bonds. What if this narrative exaggerates the effect of QE and does not pay due respect to the long-term drivers of interest rates, growth, inflation, and the supply and demand of capital?
There seems to be a consensus among investors and asset managers. The expansion of central bank balance sheets through the purchase of sovereign bonds pushed and is keeping bond yields low. Some observers suggest that the central bank’s QE has paved the way for the rise of populism by taking by neutralizing the ability of capital to go strike. If the bond vigilantes wanted to express their disapproval for a set of policies by selling or boycotting a country’s bond market, the impact would be diluted by the central bank buying.
This seems intuitively obvious, and yet it strikes us as likely wrong, leading to poorer investment choices and weaker policy decisions. Surely Italy’s recent experience offers a powerful refutation that interest rates cannot rise sharply while the ECB is buying bonds. The 10-year BTP yield jump from about 1.70% on May 4, two months after the national election, to a high on May 29 near 3.44%. Italy’s two-year yield surged from minus 33 bp to 284 bp on May 30. The ECB bought roughly the same amount of Italian bonds ( a little more than 3.5 bln euro) in May as they have bought monthly since the start of the year.
Private sector investors reacted strongly to signs that the risk that Italy would leave the monetary union were increasing based on the declaratory policy of some members of the new government. Subsequently, and perhaps beginning at the recent G7 summit and through the new finance minister’s interview in the local press, perceptions have changed. Today, Italy sold 5.63 bln euros of bonds (three to 30-year maturities), and the demand was robust. Of the four different tenors, only one was under-subscribed.
This seems to suggest that central bank buying is the not shackle on bond vigilantes. In turn, this encourages one to think through it again. Why are interest rates low? Many economists (and policymakers) doubt that the asset purchases (QE) have been particularly effective. Maybe the Fed’s first round, when interest rates were still high, it was more effective. The following rounds are thought to have less effect. Indeed ahead of the QE announcement yields would fall, but during the Fed’s QE interest rates often rose. By the time the ECB launched a proper QE ( as opposed to Trichet’s SMP effort), yields had already fallen.
Why else would interest rates be low if it weren’t for the central bank purchases? Ultimately, we would argue, that interest rates are low because growth is weak and inflation is low. There are two factors behind slower growth. Slower labor force growth, which is partly a demographic issue and it is partly a social issue, especially in the US and a few other countries where the participation rate of prime-age workers have dropped. The other element behind the poorer growth profiles is the weakness in productivity growth. Here economists have somewhat less to say. It may be some measurement issues such as output in services and capturing what some of the impact of some of the technological innovations.
Inflation is lower than one would expect given the appearance in the US, Europe, and Japan of some late-cycle economic indicators. Some measuring issues may be at work. For example, manufacturing goods inflation is more subdued than inflation in services. Wage growth has been weak as well.
During the crisis, it was easy for many to grasp that wages were sticky on the downside. Given the rise in unemployment, wage theoretically should have fallen more to clear the market. Those things that neoliberal economists “labor market rigidities” that prevent a clearing wage are the results of literally bloody fights that forged a social bargain (not contract) in the high-income economies. This is to say that non-economic factors prevent the full downside pressure to be exerted on wages.
However, it is more difficult for many to incorporate non-economic factors into the analysis of what is preventing higher wages. Yes, there are demographic issues, like experienced high paid Baby Boomers are retiring and young, less experienced lower paid employees are increasing in numbers. Automation threatens not only some lower-skilled jobs, as in retail but also skilled workers are increasing at risk.
Asymmetries of power may also help explain the stubbornly weak pay growth in several countries with full or nearly full employment, like the US (and Japan). There is one institution whose raison d’etre is bolstering workers pay and benefits, namely, trade unions. Since the late 1970s and early 1980s, the US government, for example, has made it more difficult for collective bargaining and representation. Meanwhile, owing to the consolidation and concentration of industry, often employers are in a monopsony position– i.e., monopoly or oligopoly of buyers of labor.
There is another consideration that rarely is included in such discussions. Chiefly ideological values encourage us to think about capital in a different way than any other factor of production or commodity. Many do not seem to see how the return to capital is a function of supply and demand. The lower return on capital reflects its surplus condition relative to demand. This is similar but different than Summers’ secular stagnation thesis which recognizes excess savings and the weaker demand for capital from industry. While Summers sees this as a new problem, we see it as central to market economies. My recent book, Political Economy of Tomorrow, traces this issue from the first American who presented it, Charles Conant, at the start of the 20th century, and worked here at Brown Brothers.
In the late 1970s and early 1980s, the financial deregulation was part of the solution to the crisis that ended Bretton Woods. The fixed exchange rate system proved too rigid and broke at the seams. The financial deregulation spurred innovation and the creation of a complex wave of paper assets to absorb the surplus capital. In contrast, China, like others in Asia, under-developed their capital markets. It did not create paper assets necessary to absorb their excess savings. Instead, the surplus is found in plant and equipment. It is the excess capacity.
There are important implications for investors if central banks are not the main cause of lower interest rates. For one, it means that interest rates will likely remain low even after the ECB finishes its asset purchases. It also suggests that US rates will likely remain lower than many models would suggest for a given level of growth and inflation. This has knock-on implications for setting investment thresholds for businesses and portfolio allocations.