Assuming inflation comes down in the US and Europe over 2023-24, and central banks are able to cut rates again, how far will they cut? One view is that nothing substantial has changed since the 2010’s and, once inflation is defeated, rates will slide back to zero over time, as central banks seek to boost sluggish economies. My view is that the era of zero rates is over and the ‘new normal’ is likely to see official rates settling around 3%.
Rates went down to near zero (or below in Europe) in the 2010’s and then mostly stayed there as economic growth was lacklustre and inflation was running below target. There was much talk of ‘secular stagnation’ and central banks cut rates, or added to quantitative easing, whenever the upswing flagged. Here are six reasons why we (probably) won’t go back to that.
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First, after the financial crisis in 2008, balance sheets were broken. Banks faced new capital and liquidity requirements which forced them to limit new lending. And companies didn't want to borrow either as the sudden and extreme crisis in 2008 made them review their debt and liquidity positions and operate in a much more conservative way. Households had to consolidate too as house prices fell sharply, limiting the options for mortgage borrowing even though rates were low. All this balance sheet restructuring took years and kept growth slow.
Of course, a downturn this year could still spark a new financial crisis and/or severely damage balance sheets again. But it seems unlikely to be on the same scale as in 2008. Banks have much more capital now and risk-taking has been moderate. Meanwhile, for households, the fall in both house and stock prices in 2006-9 was extreme. And while it could still be repeated, this seems unlikely unless we get a severe and prolonged recession. For one thing the surge in inflation provides a cushion for nominal asset prices.
Secondly, another important reason for the lacklustre economic recovery in the US was that house-building recovered very slowly. Normally a surge in house-building is a key driver of the early stages of the US cycle. But the US saw a massive over-build in the early 2000’s and also many potential buyers were wary.
Third, fiscal policy will likely not be as austere. This claim is uncertain, especially with the Republicans now controlling the House of Representatives, but a repeat of the fiscal cliff in the US or ‘austerity’ as practised in Britain seems unlikely.
Fourth, if the consensus view (and mine) of a mild recession is right, unemployment will not start the next upswing at nearly such a high level. In the early 2010’s US unemployment peaked at 10%, the UK at 8.5% and the euro zone at 12.2%. Today unemployment rates are half or less of that level. It would take a horrific recession to get back up there. Even if unemployment rises 2-3% from current levels in a downturn this year, (more than most forecasters expect) central banks will not view speeding up the recovery as such a priority as they did in the 2010’s.
Fifth, one reason why the 2010’s upswing was so weak was the Euro crisis in 2010-12. That took Europe into a double dip recession and damaged growth in the US and especially the UK. Of course something new could go wrong in the next few years (China crisis, new euro crisis?) but if it doesn’t the next upswing would be more robust.
Finally, central bankers really don’t want to go back to zero. They would love to have rates staying well above so that in the next crisis they have room to cut. They also recognise the criticism that financial markets and the allocation of capital were distorted by zero rates. So, if they can avoid it they won’t go there again.
Implications for investment
There are several important assumptions in the above analysis and perhaps some wishful thinking. I have laid out a scenario where we have only a mild recession this year, inflation comes down nicely and then the ensuing economic upswing is solid. But I think it makes a good case for rates staying higher in the next several years in the absence of more shocks. A key point is that the upswing does not have to be robust, only solid. For investors, persistently higher rates point to more modest stock valuations than in recent years. It also makes fixed income investing more appealing and makes the 60-40 portfolio a sensible choice again.
