BIS Blasts Fed's ZIRP Policy, Warns About Negative Side Effects From Extended Low Interest Rates

Well, at least Ben Bernanke will never be able to conduct sworn testimony claiming nobody warned him about the adverse side-effects of ZIRP. As part of its 80th annual report, the BIS has dedicated an entire chapter to diagnosing Ben Bernanke's terminal Keynesianism, entitled: "Low interest rates: do the risks outweigh the rewards?" The openly negative, and borderline critical narrative, coming from the central banks' central bank, adds yet more fuel to the rumor that there is an open schism developing between the BIS and the Fed, with the IMF's increasingly fiat-y SDR likely to suffer as a result. Whether the BIS is planning the creation of some non-fiat currency, as some have speculated, is unknown at this point.

Here are some of the BIS' critiques of what an "extended" period of "extremely" low interest rate will bring to the world:

History offers little guidance on the economic significance of the side effects of unconventional monetary policy. By contrast, distortions arising from low interest rates have been observed in the past. In this chapter, we review these risks in the current context and argue that, if not addressed soon, they may contain the seeds of future problems at home and abroad. In doing so, we draw on lessons from the run-up to the financial crisis of 2007–09 and on Japanese experiences since the mid-1990s.

First - "Low interest rates caused misallocations before the crisis …"

Previous episodes of low interest rates suggest that loose monetary policy can be associated with credit booms, asset price increases, a decline in risk spreads and a search for yield. Together, these caused severe misallocations of resources in the years before the crisis, as evidenced by the excessive growth of the financial industry and the construction sector. The necessary structural adjustments are painful and will take time.

Second - "...And are now delaying necessary adjustments"

In the current setting, low policy rates raise additional concerns since they are accompanied by considerably higher long-term rates. This may lead to a growing exposure to interest rate risk and delays in the restructuring of the balance sheets of both the private and public sector. The situation is further complicated because low interest rates may have caused a lasting decline in money market activity, which would make the task of exiting from loose monetary policy more delicate.

Third - "Low interest rates have an impact on risk measures and perception. This contributed to rising asset prices
before the crisis. And may be at work again today."

Standard economic models predict that a decrease in real interest rates causes faster credit growth, if it is expected to be sustained. Moreover, it raises asset prices since it drives down the discount factor for future cash flows. Other things equal, this leads to a rise in the value of collateral, which may induce financial institutions to extend more credit and to increase their own leverage to purchase riskier assets. Rising asset prices are also often associated with lower price volatility, which is reflected in lower values for commonly used measures of portfolio riskiness such as value-at-risk (VaR). These factors in turn reinforce the amount of capital invested in risky assets and the increase in asset prices and lead to a further narrowing of measured risk spreads. This mechanism is widely seen as a major driving force behind the increase in asset prices and the decline in risk spreads in the run-up to the financial crisis of 2007–09. Starting in the spring of 2009, a fast recovery in global equities and a rise in house values in many economies (the euro area and Japan are exceptions) were accompanied by a reduction in corporate bond spreads and other risk premia (Graphs II.1 and III.2, top panels), though some risk measures have meanwhile risen again in the context of the Greek sovereign debt crisis. The broad rise in asset prices and the reduction in risk spreads that took place in 2009 and the early months of 2010 is thus best seen as reflecting both the success of these policies and a new build-up of potentially overly risky portfolios.

Four: "Low policy rates can induce a search for yield"

Risky portfolios can also result from a search for yield, whereby low nominal policy rates lead investors to take on larger risks in pursuit of higher nominal returns. In the years preceding the financial crisis, many investors targeted a nominal rate of return that they thought was appropriate based on past experience. Furthermore, institutional investors, such as insurers and pension funds, faced pressure to fulfil implied or contractual obligations made to their customers at a time when nominal returns had been higher; they looked for those returns in alternative investment opportunities. The fact that many compensation schemes were linked to nominal returns also contributed to the search for yield.

Five: "This may drive up asset prices fuel financial innovation and discourage real investment"

A number of symptoms can indicate a search for yield. The first is an increase in asset prices and a reduction in risk premia. While the recovery in many asset markets in 2009 and early 2010 in part represented a reversal of crisis-related risk aversion, the search for yield phenomenon, against the background of near zero policy rates, may have started to play a role towards the end of this period.

A second symptom is distorted financial innovation. In the early 2000s, intermediaries responded to investors’ desire for higher returns by engineering financial products that appeared to minimise the risk associated with them. A large variety of these “structured” products were widely sold in the years before the crisis. On the surface they appeared to embody the investor’s holy grail of low risk and high yield, but during the crisis their character proved to be the opposite. As a consequence, the market has become reoriented towards less exotic investment products. That said, financial innovation is difficult to monitor and the shortcomings of new products are easier to spot with hindsight.

A third symptom can be an increase in dividends and share buybacks. If investors expect high nominal returns and if these are difficult to come by, non-financial corporations may find themselves under pressure to return funds to investors rather than pursuing risky but economically profitable real investments in new plants or research and development.

Six: "Low policy rates can steepen the yield curve exposing banks to interest rate risk"

Low policy rates in combination with higher long-term rates increase the profits that banks can earn from maturity transformation, ie by borrowing short-term and lending long-term. Indeed, part of the motivation of central banks in lowering policy rates was to enable battered financial institutions to raise such profits and thereby build up capital. Increasing government bond yields, caused by ballooning deficits and debt levels and a growing awareness of the associated risks, make the yield curve even steeper and reinforce the appeal of maturity transformation strategies. However, financial institutions may underestimate the risk associated with this maturity exposure and overinvest in long-term assets. As already noted, interest rate exposures of banks as measured by VaRs remain high. If an unexpected rise in policy rates triggers a similar increase in bond yields, the resulting fall in bond prices would impose considerable losses on banks. As a consequence, they might face difficulties rolling over their short-term debt. These risks may have increased somewhat in the aftermath of the 2007–09 crisis, because the poor credit environment for banks and the greater availability of central bank funding have left many banks with funding structures skewed towards shorter maturities. A squeeze on banks’ wholesale funding might set off renewed asset sales and further price declines.

Seven: "Low policy rates can delay the restructuring of balance sheets"

One legacy of the financial crisis and the years preceding it is the need to clean up the balance sheets of financial institutions, households and the public sector, which finds itself in a poor fiscal position, partly as a result of the rescue measures adopted during the crisis. Low policy rates may slow down or even hinder such necessary balance sheet adjustments. In the financial sector, the currently steep yield curve provides financial institutions with a source of income that may diminish the sense of urgency for reducing leverage and selling or writing down bad assets (see also Chapter VI). Central banks’ commitment to keep policy rates low for extended periods, while useful in stabilising market expectations, may contribute to such complacency.

Eight: "The adjustment of public finances may also be delayed"

Low interest rates may also delay necessary balance sheet adjustments in the public sector (see Chapter V for more details). By shifting their debt profile towards shorter-term financing, governments can reduce interest rate payments. While this provides them with useful breathing space for returning sovereign debt levels to a sustainable path, it also exposes fiscal positions to any increase in policy rates if the needed budgetary adjustments are not put in place in a timely manner. This can raise concerns about the independence of monetary policymakers.

Nine: "Low policy rates can paralyse money markets and complicate the exit"

Once central banks begin the exit and raise their policy rates, it is essential that money markets transmit this change to the wider economy. However, low policy rates can paralyse money markets. When the operational costs involved in executing money market deals exceed the interest earned – which is closely related to policy rates – commercial banks may shift resources out of these operations. Japanese money markets suffered such atrophy: the turnover in the uncollateralised overnight call market fell from a 1995–98 average of more than ¥12 trillion per month to a 2002–04 average of less than ¥5 trillion. As a result, the tightening of Japan’s monetary policy in 2006 was complicated by overstretched staff on the money market desks at commercial banks. In the current setting, one reason why many central banks have refrained from lowering their policy rate all the way to zero during the recent financial crisis has been to avoid precisely this problem. International differences in how close policy rates got to zero are probably related to diverging money market structures.

Ten: "Low policy rates also cause distortions abroad"

Low interest rates in the major advanced economies cause side effects beyond their borders, both in emerging markets and in commodity-exporting industrial countries, which fared comparatively well in the crisis. The initial impact of the financial crisis on these countries was in most cases a sharp decrease in exports (Graph III.4, top panels), a withdrawal of US dollar funds by foreign banks, liquidation of equity and bond holdings by investors, and a drop in equity prices. The large emerging economies and the advanced commodity exporters experienced a considerable weakening of their exchange rates against the US dollar in the autumn of 2008, except in the case of China, which held the renminbi fixed (Graph III.4, middle panels). Monetary policy was loosened, both through lower interest rates and – in China, India and, later, Brazil – through lower reserve requirements (Graph III.5). Moreover, many central banks locally offered US dollar funds that some had obtained through swap lines with the Federal Reserve.

And the BIS' damning condemnation:

The recent market turbulence associated with sovereign debt concerns is likely to have postponed the necessary return to more normal monetary policy settings in a number of advanced economies. Exactly when monetary conditions will be tightened will depend on the outlook for macroeconomic activity and inflation, and on the health of the financial system. But keeping interest rates very low comes at a cost – a cost that is growing with time. Experience teaches us that prolonged periods of unusually low rates cloud assessments of financial risks, induce a search for yield and delay balance sheet adjustments. Furthermore, the resulting yield differentials encourage unsustainable capital flows to countries with high interest rates. Because these side effects create risks for long-term financial and macroeconomic stability, they need to be taken into account in determining the timing and pace of normalisation of policy rates.

Bernanke - you have now been officially warned. Playing dumb is no longer an option.

Full BIS Report: