"Low for Long" Policy Rates: Required for Global Economic Balance

Are things better now?

Have things improved so decisively during the last years for those low rates not to be necessary anymore? This is far from sure.

The risks attendant to some of the mortgages that were outstanding three years ago do not have to be carried anymore because the loans have been either paid back or written-off. New loans have however been made since 2007, so that the amount of mortgages outstanding in the US has diminished by only $300 billion. Moreover, the new mortgages may carry less credit risk but are still long-term, so that the maturity-transformation risk has not vanished.

On top of this, the Federal Reserve has relieved the system from a significant part of the maturity-transformation positions that somebody had to hold. The Fed now has $1,500 billion dollars of mortgages on its books (i.e. long-term debt) financed by banks’ excess reserves holdings (i.e. short-term funding). By taking on the positions that investment banks, hedge funds, or off-balance sheet vehicles could not take anymore, the Fed played a key role in bringing the global financial system back to stability.

But since 2007, the global imbalances have not disappeared (see for example Baldwin and Taglioni 2009 and Claessens et al. 2010). Close to $2,000 billion of additional savings have been transferred following roughly the same risk-taking patterns (Figure 1). For a while, however, there seemed to be one notable difference: the securities now issued in the deficit countries as a counterpart of the savings being accumulated in the surplus countries are now government debt instead of private mortgages. We might have hoped that this at least did not imply a build-up of credit-risk positions… until it appeared that not all government debt can be considered as being credit-risk free. In just a few weeks, the deepening of the Eurozone debt crisis made more than $1,500 billion of public debt¹ look like “subprime” government securities, riskier to hold and more difficult to fund!

Conclusion

On balance, it looks likely that the Western financial system will still have to hold more maturity-transformation and possibly credit-risk positions than it can. A premature upward move in policy rates would put its stability at risk. From this perspective, the fact that this move may be further postponed is reassuring. It does not mean that low rates have no side effects, but, for a while at least, those side effects can and should be taken care of by other means than rate hikes.

References

Adrian T and HS Shin (2008), “Liquidity, Monetary Policy, and Financial Cycles”, Current issues in economics and finance, Federal Reserve Bank of New York.

Baldwin, Richard and Daria Tagloni (2009), “The illusion of improving global imbalances”, VoxEU.org, 14 November.

BIS Annual Report (2009/10), “Low interest rates: do the risks outweigh the rewards?”, Chapter 3.

Brender A and F Pisani (2010), Global imbalances and the collapse of globalised finance, CEPS, Brussels.

Claessens, Stijn, Simon J Evenett, Bernard Hoekman (2010), Rebalancing the global economy: A primer for policymaking, A VoxEU.org publication, 23 June.

1 This includes the government debt of Greece, Ireland, Portugal, and Spain.