Are we facing a protracted period of 'secular stagnation' that no central bank can fix? How much longer can the zero-rate economy continue and how can we climb out of the 'liquidity trap'?
After seven years at 0-0.25%, the Federal Reserve finally raised its intended rate to a range of 0.25-0.5% in December 2015: the first rate hike since June 2006. While the small raise was widely expected, it hasn't been celebrated as a sign that the US economy is springing back into health. And although the Fed itself has indicated that it intends to raise interest rates to 1.375% by the end of 2016, economists are predicting that 2016 will see interest rates remain below 1%, with little prospect of a financial recovery.
There are several diagnoses of the problem, according to the Economist. One is that central banks are suffering from a form of paralysis that is “either self-induced or politically imposed”. This is stopping them from effectively using quantitative easing, which should in theory stimulate an economic recovery. Another analysis of the problem is that, once a central bank introduces a near-zero interest rate, they are practically helpless and in such an environment, even quantitative easing cannot kick-start the economy, mainly because there aren't enough borrowers in the market. A third interpretation of the current situation is that there are too many savers in the market and too few attractive investment options.
The liquidity trap
All three interpretations are connected and are more likely different views of the same phenomenon (as in the parable of the six blind men and the elephant), and are all manifestations of the so-called 'liquidity trap', an idea developed by economists John Hicks and Paul Krugman.
But the fact remains that if we compare the current financial doldrums to previous cycles – such as the US Depression in the 1930s and Japan's recession in the 1990s – then there is little reason for cheer in 2016.
But economists' understanding of the liquidity trap is developing. Milton Friedman and Anna Schwartz say that central banks can fight their way out of financial slumps – if their policies are sufficiently aggressive. The Fed has tried and abandoned quantitative easing. It's trying to move away from zero anyway but there is little belief in the financial markets that this move will work.
There is yet another idea that what we are currently experiencing is 'secular stagnation', a scenario in which, as the Fed raises interest rates, the value of the dollar will also rise, keeping inflation low, which will in turn force the Fed to lower rates once again. Other countries will also be sucked into this downward spiral towards zero-rates, making for a bleak outlook not just in the short term but also in the long run.
Cash flows will also affect interest rates in 2016. As mentioned above, for quantitative easing to work, governments need borrowers to purchase bonds. Indications from Federated Investors show that borrowers are more inclined to leave cash in Prime money funds rather than move it to government bonds. And with rates for deposit accounts likely to remain very low, there is less incentive to place cash in deposit accounts.
Cash flows: supply and demand
The reverse repo market has also become more instrumental. The cap on the amount of collateral approved participants can ask has been raised from $300 billion to about $2 trillion, which may satisfy demand. In any case, supply and demand among investors and borrowers will have a strong influence on whether the Fed's rate rises will be effective in stimulating a recovery in 2016.
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