06/01/2015 - 15:25

Why is there no upward pressure on interest rates?

06/01/2015 - 15:25


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To understand global interest rate trends, and their impact on Australia, we need to look closely at the actions of central banks around the globe.

To understand global interest rate trends, and their impact on Australia, we need to look closely at the actions of central banks around the globe.

Until recently some tightening was commonly anticipated in global financial markets, which in turn was seen as being likely to place upward pressure on financing rates in Australia and downward pressure on prices of stocks and other assets. 

This expectation stemmed from developments in US monetary policy. 

Recall that the US supplies a fifth of global output and that it is the most financially open and productive of all the large economies. 

Post the GFC, the US Federal Reserve (Fed) embarked on an unprecedented monetary stimulus, via what became known as quantitative easing (QE).

Conventional monetary stimulus, relying on central bank holdings of short maturity financial assets, had been exhausted when, mid-GFC, interest rates on these assets approached the zero lower bound. 

The Fed resorted to unconventional asset holdings which, in the US, comprised a combination of long term Treasury bonds and mortgage backed securities, the former dominating in the early phases and the latter more recently. 

The stated objectives of this were to raise the monetary base sufficiently to tame deflationary forces, to induce a more healthy demand for productive assets and, ultimately, to reduce the rate of unemployment. 

In the third phase, entitled QE3, this took the form of open-ended purchases at a rate of $85 bn per month delimited only by the prospect of the US unemployment rate eventually falling below six per cent.

In mid-2013 it was announced that this buying program would be “tapered” over the year to come.  The effect of this was to stimulate a private scramble out of long bond holdings that saw their yields rise from below two per cent to three per cent in a few months. 

This was referred to as the “taper tantrum”.  But the Fed bond purchases continued and yields stabilised again. 

The announced taper actually began in December 2013 and, as the unemployment rate fell below six per cent, it ended with a final $15 bn purchase in October 2014. 

But herein lies the puzzle. There was no further “tantrum”. 

The path of long term interest rates has shown no tendency toward a lasting increase.  How can purchases at such a high rate cease without causing the price of these globally significant bonds to fall and hence their yields to rise?

There are many stories that might explain this. 

One claim is that the credibility of the US commitment to ending QE is doubtful, but the December 17 Federal Reserve Statement on Monetary Policy indicates that dissenting board members preferring not to rule out a return to QE were out-voted by a clear majority. 

Another is that, with the gradual narrowing of the US fiscal deficit, the supply of long term Treasuries has declined.  This is a credible contributor, though US government financing requirements remain considerable.

A number of explanations relate to the US underlying real recovery, which is quite strong, at least compared with other developed regions. 

One of these is that higher growth in the US generates greater expected returns and that this attracts private financial inflows. 

These, in turn, tend to appreciate the US$, inducing central banks in other regions (especially in China and Japan) to rebalance their portfolios toward US Treasuries. 

The nominal effective US exchange rate has indeed appreciated, by almost six per cent in the second half of 2014. 

While concrete data on very recent foreign purchases of US Treasuries is not yet available, there are further reasons to expect such purchases to have increased recently. 

China is the largest single foreign holder of US Treasuries and it has a clear interest in sustaining their value.  In the case of Japan, also a large foreign holder, its own QE has been proceeding strongly under Abenomics, but it has caused Japanese short and long bond yields to fall near the zero lower bound. 

Further monetary expansion requires the acquisition by the Bank of Japan of other assets.  Purchases of US Treasuries meet this requirement, with the complementary benefit that they further depreciate the Yen. 

Finally, there is the effect of the US real recovery on private US demand for Treasury bonds, and those assets that arbitrage closely with them.  The volume of US private saving is increasing and some if it is chasing such assets.

In sum, then, while the US is now contributing less to the global liquidity flood, central banks in Europe and Japan appear to be taking up the slack and acquiring US assets in the process. 

While ever interest rates outside the US remain low for this reason, a US recovery that causes investors to expect an appreciating US$ implies that US interest rates will tend to decline rather than to increase. 

Prospects for any associated financial tightening in Australia therefore tend to recede, the more so given the negative effects on our economy of recent commodity price declines.


Dr Rod Tyers is a Winthrop Professor Economics at the University of Western Australia Business School.


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