"Kee" Points with Jim Kee, Ph.D.

  • Forecasting Interest Rates  
  • On Negative Rates  


Forecasting Interest Rates

I have had a lot of questions from clients regarding negative interest rate policies, so in this week’s Kee Points I thought I would take a stab at explaining them. As a preliminary remark, I would be wary of those portending to be able to predict interest rates; they are set globally by trillions of dollars, and few people are smarter than the global bond market! When I worked for a macroeconomic forecasting firm, and this was over 20 years ago, we were perplexed that interest rates were so high. Our model, which used a lot of historical and forward-looking data to forecast interest rates, always said rates should be lower. That is, given expectations for real economic growth, inflation, etc., we consistently found rates to be higher than a quantitative model would predict. Our conclusion at the time was that there must be a “fiat currency premium” built into interest rates. Although inflation was in check, since currencies weren’t backed by anything like they were under the Bretton-Woods system (early 1970s), the market was probably baking into interest rates an expectation of inflation. In other words, there was more risk to paper money than the gold-backed money we (loosely) had under Bretton Woods. Well, fast-forward to today and we still have a paper or fiat currency (made legal by government decree only, not backed or convertible into something else). Interest rates are (and have been) below what most historical data would predict, given assumptions for growth, inflation, and perhaps even global capital flows. So much for the fiat currency premium thesis! I guess my point is that interest rates are just as perplexing as always (!), and I wouldn’t put a lot of money into strategies predicated on predicting them. 


On Negative Rates  

On negative rates, I have been influenced by comments and writings of former Fed Chair Ben Bernanke, who has argued that anxiety about negative rates in the media is overdone. Economists tend to be less bothered by negative rate policies because our models tend to focus on “real interest rates” (nominal interest rates minus inflation), and real rates – at least short term rates like the federal funds rate – are often negative. Bernanke points out that there is no real disconnect or discontinuity in going from, say, +.2% interest rates to 0% and down to -.2%. It is just a move down, like going from +.4% to +.2%. In other words, to economists it’s the real rate that matters, and the media just hypes the negative rate narrative.


The point of most interest rate targeting schemes is to push down longer-term rates, like mortgage rates, that are most important to consumers and businesses. The hope is that they will then borrow and spend more, stimulating the economy. One way to do this is for the Federal Reserve to buy short-term securities, pushing up their prices and pushing down their yields. The sellers of those securities (mostly banks) then use the proceeds to buy longer-term, higher yielding securities. This pushes up their prices, and pushes down their yields. In that way, it is hoped that lower interest rates permeate the term-structure (i.e. from short to long term), lowering those longer rates that are important to businesses and consumers. Another way for the Fed to achieve the same goal is by buying longer-term securities directly, which increases the prices of (and lowers the yields of) those longer-term securities directly. This has been a more recent tool used by the Fed and other central banks and has come to be known as quantitative easing.

 

Negative interest rates are yet another (a third) means to achieve this end of lowering longer-term rates and stimulating the economy. This has been tried in Switzerland, Sweden, Japan, and the euro area. The idea here is that the central banks actually charge banks for the reserves that they hold for them (private banks hold reserves, i.e. a percentage of their deposits, at central banks). That means it costs banks to hold reserves at the central bank, so instead of making loans and earning interest, they are paying it! The expectation is that, in order to avoid the fees, banks will start making loans, i.e. shifting those funds to other short-term assets (I’m citing Bernanke here), driving their yields down and again hopefully transmitting lower rates throughout the system. If you think about it, if rates go too negative, then banks and people will just hold currency (“hoard currency”) rather than pay the central bank to hold it. That has costs too (storage, security, etc.), but the point is that there is some theoretical negative rate, below which currency hoarding will negate any stimulative impact on the economy.


The negative rate policies enacted in various parts of the world haven’t really been effective at stimulating growth (mortgage rates and other business loan rates in those areas are still generally positive), but many argue that they haven’t been entirely ineffective either. That, too, doesn’t really surprise economists, who typically ascribe much less power to monetary policy for stimulating growth than layman or “media” economists do.