Should We Expect Central Banks to Lower Rates to Near Zero by 2023?

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An upcoming recession could cause central banks to lower rates to zero.

Most probably yes. As the economy comes full-cycle, there is the expectation that a global recession will lead to central banks implementing unconventional monetary policies to decrease their benchmark rate to near zero to motivate borrowers/investors to borrow money and stimulate the economy. The near-zero rate is likely to also be supplemented with quantitative easing (QE) to lower long-term bond yields and provide banks with more liquidity.

Recession, an inevitable component of the economic cycle

Keen observers of economic events would have noticed the cyclical nature of economies– with alternating periods of expansion and contraction. During an economy’s expansion phase, there is a marked increase in production, sales and steady cash flow. With average growth rates of 2-3% and an inflation rate of 2%, a Goldilocks economy can remain in the expansion phase for a pretty long time. As soon as the economy reaches its peak in the business cycle and attains its maximum level of growth, a contraction usually inevitably follows. The contraction period starts with a recession and is typically followed by a depression, then a trough (the end of the depression) and finally, the economy recovers and the cycle starts all over again.

Typical business cycles last less than 10 years. As the last recession was over 12 years ago, a critical study of global economies has led to the belief that we might soon experience another recession, with 9 out of 10 experts agreeing that a global recession is likely to occur by the end of 2022

How will a global recession affect interest rates?

During the growth phase of the business cycle, economic growth and expansion often lead to inflation. In a bid to keep inflation around 2%, central banks will likely institute monetary policies that increase the interest rate they charge for loans to banks. This and other factors then make banks increase interest rates on credit and loans for the public, and eventually, the amount of money in circulation falls and inflation is controlled.

Conversely, when an economy is in the contraction phase, central banks often implement monetary policies to lower interest rates. This motivates buyers to spend more and also businesses to keep investing, stimulating the economy. This phenomenon of rising and falling interest rates around a specific rate is known to experts as the mean reversion of interest rates and it is a feature of a properly managed economy with an independent central bank and stable growth and inflation rates. 

If a global recession does occur, central banks are likely to adopt their standard procedures and reduce interest rates. 

Is the use of negative interest rates a normal approach by central banks?

As of early 2020, the current state of economies around the world is that of growth (i.e. economies are still in the expansion phase of the cycle). Considering the previous cycles, inflation rates are expected to rise to much higher levels than what are currently set by federal governments around the world.  

For example, Canada currently experiencing a historically low benchmark interest rate of 1.75%, and home buyers as of February 2020 can get a 5-year mortgage rate for as low as 2.43%. In the United States, the central bank’s Federal Open Market Committee has also set its benchmark federal funds rate at between 1.5-1.75% to keep the inflation around 2%.   

Interest rates are usually pushed lower in a recession in order to stimulate spending and prevent deflation. But unlike previous cycles, we currently have historically low interest rates, despite being in a growth phase. When economies face a global recession, central banks such as the Bank of Canada and US Federal Banks might have to move interest rates close to zero or even below zero (negative interest rates) to stimulate the economy since there isn’t much room left. For example, in response to the Great Financial Crisis in 2008, the Bank of Canada dropped interest rates from 4.5% until it got to a lower bound of 0.25% in 2009. In the US, the Federal Bank dropped the Federal fund rates from 5.25% in August 2007 to 1% in 2008. 

Negative interest rates don’t make sense from a standard economics standpoint. Assuming an annualized 1.75% interest rate on a $10000 loan from the central bank, the borrowing bank would have to repay the initial amount as well as an additional $175 interest after one year elapses. However, a negative interest rate of about -0.25% would mean the central bank pays the retail bank an additional $25 on repayment of the loan, which means they lose money by giving out the loan. Although most companies and borrowers from retail banks will stay have to pay interest on their loans, this can also distort the borrowing market. 

Nonetheless, there are times (e.g. during a recession) when the best option for economic stimulation by central banks is the introduction of an unconventional monetary policy tool like the Zero Interest Rate Policy or ZIRP.

This phenomenon, though unconventional, is not entirely new. Negative interest rates were first deployed by the European Central Bank (ECB) in 2014 with a -0.1% deposit rate, and by the Japanese Central Bank (JCB) in 2016 with -0.1%. More central banks are expected to follow suit in future recessions.

What are the implications of a global recession on the economy?

When introduced, negative interest rates have significant implications on different aspects of the economy. We will be specifically discussing the impact of recessions and low interest rates on the job market, the real estate market and the stock market.

The job market

The recession predicted to happen by the end of 2022 will almost definitely lead to layoffs and a decline in job opportunities. To keep your head above water financially, it is best to prepare ahead for potential job loss by paying more attention to savings and investments. You should also update your skills constantly so you’d find a job quickly in the eventuality of job loss.

The real estate market

With lowered interest rates, the cost of financing a house will decrease. Your location will also play a great role. There are specific differences in mortgage structure between Canadian and US real estate markets, with Canadian real estate investors holding shorter mortgage terms. This means that with Canadians mostly using 5-year fixed mortgages rates to buy a property, they may switch or renew to new mortgages with lower interest rates if a recession happens. Mortgage terms in the US on the other hand, are longer i.e. 15-year or 30-year mortgages. 

There’s also an effect of the job market on real estate, as reduced employment during a recession would lead to less interest in buying properties and drops in home prices. As a home buyer, you need to carefully note the characteristics of an area’s real estate market before you buy a house there.

The stock market

When considering the impact of a global recession and negative interest rates on financial indices such as the stock market, one important metric is the Price-to-Earnings Ratio (i.e. P/E ratio) which measures a company’s current share price in relation to its per-share earnings. This metric is useful for determining the relative value of a company’s shares, for comparison of aggregate markets over time, or to observe a company’s historical performance over a 10 or 30-year period. 

Companies are currently valued at very high P/E ratios as typified by S&P stocks. During a recession, company earnings and share prices will witness a sharp drop. With much lower expected growth, if any, there will also be a significant reduction in P/E ratios, furthering the drop in share prices beyond simply a drop in earnings.

To minimize a recession’s effect on stocks, stock market investors are advised to diversify their portfolio in favour of recession-proof stocks. For example, luxury markets like high-end branded bags/shoes and first-class tickets will be hit harder than consumer staples like the food sector since people will cut back on luxury spending during a recession but will still need to buy their basic supplies and groceries. Another solution is to invest in Exchange Traded Funds (ETFs), which are a basket of pooled securities belonging to one asset class like equities bonds. Investing in an ETF gives you a broader asset base and is less risky than investing in single stocks.

The bottom line

With a global recession looming, there is an increased likelihood of central banks set even lower benchmark interest rates (e.g. negative interest rates) to stimulate the economy. A recession will lead to job losses, decreased cost of financing in the real estate industry and a sharp drop in stock prices. As this is projected to happen within the next 3 years, adequate preparation will help you maintain a competitive edge in the global market. You could even be able to use it as an opportunity to invest in stocks and real estate when the prices go down significantly, and profit once the economy recovers.

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