A recent speech at the Shanghai Advanced Institute of Finance in Beijing, China by Boston Federal Reserve Bank President Eric Rosengren looks at global financial stability and one of the concerning issues that unprecedented central bank intervention has caused since the Great Recession. This is part two of my ongoing series, looking at the unintended consequences of the ultra-long period of near-zero or negative interest rates.
Here are his opening comments:
"It is a pleasure to be here in Beijing to share some observations. Let me begin with the obvious: growth in the global economy has continued to underwhelm. In response to these disappointing economic results, central banks in many developed countries have reduced short- and long-term rates to historic lows. Indeed, a number of countries now have negative rates on a significant proportion of their sovereign debt. In the financial sector, the low rate environment has continued to challenge the business models of many financial intermediaries, and troubles within some banking organizations continue to present downside risks in many parts of the world, particularly in Europe. And it is not only developed economies that are facing challenges; many emerging economies are still suffering from the decline in global commodity prices which has resulted, in part, from the slow growth across much of the world."
He goes on to note that, even though the U.S. economy is weak by historical standards, the rate of unemployment is close to the rate that economists consider "full employment" (see, central bankers do have a sense of humour!) and core inflation (PCE or Personal Consumption Expenditures price index) at 1.6 percent is approaching the Fed's target of 2.0 percent. Given the Federal Reserve's "great" success at nearly achieving its dual mandate, Mr. Rosengren ponders when and how quickly the Fed should normalize interest rates from their long period of nearly zero percent. He believes that the Fed has acted responsibly but only gradually increasing rates for two reasons:
1.) gradual tightening allows for the labour market to continue to help those who are either unemployed or temporarily out of the workforce, a very significant problem that has kept the U-6 unemployment rate much higher than during other economic expansions as shown here:
He notes that tighter labour markets should help the inflation rate return to the Federal Reserve's target of 2 percent.
With that background, he goes on to state the following:
"By slowly normalizing rates, we would hope to continue to support growth. However, keeping interest rates low for a long time is not without risks.'
He cites the following problems associated with the prolonged period of ultra-low interest rates:
1.) Financial intermediaries who derive their income from spread-lending (i.e. borrowing at low short-term rates and lending at a higher rate for longer periods of time. In an environment where both short-term and long-term rates are low, there is no profit margin.
2.) Households who are trying to save for major purchases and/or retirement find it increasingly difficult to get a return on low risk investments.
As I have noted before, the long period of near-zero interest rates has created a "reaching for yield" environment where households and corporations purchase riskier assets than they normally would in an effort to get a reasonable yield.
Here's another quote from his speech:
"The challenge is that in a pervasive low-rate environment, the returns on risky assets are also reduced. A key risk to an environment characterized by reaching for yield is that, should a large negative shock occur, firms and households would be exposed to greater losses through their holdings of riskier assets than they would be if they were not reaching for yield. To the extent that reaching for yield is more likely in a low interest rate environment, policymakers may need to weigh this particular risk related to low rates against the benefits of supporting the economy." (my bold)
Now, let's look at one sector of the economy that concerns Mr. Rosengren; the rapid rise in commercial real estate prices in the United States. As interest rates have remained low for an extended period, commercial real estate prices have risen, pushing the capitalization rate (the ratio of net operating income produced by a property divided by the price paid for that property) to historic lows, in other words, the returns on commercial property as an investment have plummeted as prices of commercial property have risen thanks to the never-ending search for yield by investors.
To give you a sense of the extent of the problem, here is a graphic from the presentation comparing the year-over-year growth in real GDP (in dark blue) to the year-over-year growth in real commercial real estate prices (in green):
Note how real commercial real estate prices track economic cycles; when the economy is weak, the price for commercial real estate drops, sometimes very deeply as we saw during the Great Recession. Why should this concern us? Here is a table showing who is lending the money to purchase commercial real estate in America:
Banking institutions which include U.S. chartered depository banks and foreign banking offices in the United States are by far the largest holders of commercial real estate mortgages, holding a total of $2.047 trillion worth. Non-agency commercial mortgage-backed securities which includes real estate investment trusts (REITs) are next at $498.1 billion followed by life insurance and property casualty insurance companies, private pension funds and state and local government retirement funds come in third place, holding $369.7 billion worth of commercial real estate mortgages. While these are relatively small compared to the size of residential mortgages, a significant decline in the value of commercial real estate could lead to large losses in the banking sector, losses that would have an impact on credit that is available to households and Corporate America.
How significant has the rise in prices for commercial real estate been? Here is a graphic showing the rise in the price indices for apartments, office properties, industrial properties and retail properties since Q4 2000:
Here's what has happened to the capitalization rate (the ratio of net operating income produced by a property divided by the price paid for that property) as commercial real estate prices have risen:
Capitalization rates have dropped largely because increases in rent have not kept pace with the rise in the market price of commercial properties. As you can see on this graphic, the drop in the capitalization rate has tracked the dropping yield on ten-year Treasuries:
And, what does Mr. Rosengren have to say about that?
"As the 10-year Treasury rate has fallen, along with rates on sovereign debt in much of the world, households and firms have been turning to the relatively high returns possible in real estate. This should not be surprising; one of the ways that monetary policy works in a low-interest-rate environment is to encourage investors to move into somewhat riskier asset class categories, to stimulate economic activity. Of course, should macroeconomic conditions change, there is a potential for large losses to those who moved into riskier assets, as previously discussed. "(my bold)
Mr. Rosengren closes by noting that a drop in the value of commercial real estate is unlikely to trigger financial stability problems in the way that the collapsing housing market caused the Great Recession. However, he does state that:
"Should the macroeconomic environment change, one could envision a scenario where commercial real estate prices could decline significantly if underlying rents, occupancy rates, and market interest rates become less favorable. The probability of such a reassessment is, of course, each market participant’s to judge, and I am not making a prediction of this outcome, to be sure. But I have emphasized that such a revaluation, in conjunction with an economic downturn, could make a recession worse than it would have been had policymakers normalized interest rates more rapidly." (my bold)
Unintended and painful consequences for questionable monetary policy seem to be lurking around every corner thanks to central banks and their braintrusts who believe that the only way to stimulate the global economy is through the use of ultra-low, zero or negative interest rates. Asset bubbles seem to be the order of the day given the very low rates of return on just about every low-risk financial product that is available. From Mr. Rosengren's analysis, we can see that a significant drop in the value of commercial real estate is quite likely should the Fed tighten. As he told his audience:
"...it is important that central banks think about attainment of their mandates not only at the current time, but also through time. Policymakers must weigh the benefits of low interest rates now against the potential costs in the future of possibly spurring financial instability that will ultimately have downstream adverse effects on firms and households."
I think it's a bit too late for a cost-benefit analysis for the long period of unprecedented monetary easing.