Escape velocity – stop obsessing about policy rates

Our obsession with policy rates could well be unhealthy. As an industry we pour over Fed minutes, try to infer secret meaning in Q&A sessions at press conferences, and look eagerly for signs of central banks being either behind or ahead of the curve. With the benefit of hindsight we often look back at ‘obvious’ policy mistakes and seek to explain the past through the lens of policy decisions (see figure 1).

Figure 1: ‘Obvious’ policy errors… with hindsight

Why do we do this? Largely because looking at the decisions of central bankers combines two related elements that human beings love when trying to make sense of the world:

  1. It offers a simple, ‘other things being equal’ model of the world. Assuming that a rate increase results in X outcome is not only intellectually appealing, but is far easier than confronting the dynamic complexity of the real world.
  2. It is salient. Fed minutes, rate decisions, and press conferences, all come at distinct moments in time. There was an environment before the event, and then there was a date when things changed. This is not the case with more abstract or slow moving ideas like ‘globalisation,’ ‘demographic change’ or ‘technological revolutions.’ These are far harder to pin down and this is why it is often easier to just ignore them and focus on day to day details and headlines, even if these details are really just noise.

Of course rates are important, and especially so for investors. The Fed Funds rate is arguably the global ‘risk free rate;’ the foundation on which the valuation of all assets stand. But we run risks of adopting a dangerous tunnel vision, especially when assuming that rate decisions will ‘inevitably’ impact the real economy in certain ways.

The last couple of years are a good example. Basic economics suggests that lowering rates increases economic activity by penalising companies and households for holding cash, inciting them to do more productive things. The problem is that a whole host of factors drive decisions to take risk: the regulatory and structural regime, pre-existing levels of indebtedness, perceptions of risk based on past experience and so on. Moreover, the market can frequently have more impact on the easiness or otherwise of monetary conditions. How much easier are conditions in the Eurozone given the fall in government bond yields and corporate bond spreads, not to mention the recent decline in the oil price (see figure 2)?

Figure 2: Market easing.

With hindsight therefore we should probably not be too surprised when policy rate changes don’t produce the outcomes we may expect. It should not necessarily be a ‘conundrum’ that ultra-low rates have failed to create the speed of recovery we have seen in the past (irrespective of whether we believe in the secular stagnation thesis or not).

Ultimately, animal spirits are what matter. If people do not believe they can do profitable things with their money (or need to be paying down, rather than increasing debt), then rate cuts or throwing cash for banks to lend out will do very little to persuade them otherwise. If you are an investor, as opposed to a speculator, these are the dynamics you should care about, not 25bps moves in policy rates.