Negative interest rates & a negative opinion of Central Banks & Macroeconomics

  • The IMF have downgraded their global economic forecasts
  • The European economy is struggling so driving the ECB to relaunch QE
  • The U.S. economy has grown well, however, it has a feel of recession on the horizon
  • There is an urgent need for a rethink as to how macroeconomics provides solutions

GDP growth forecasts for the global economy by International Monetary Fund (IMF) in its World Economic Outlook (WEO) were pitched at 3.2% in 2019 with the expectation for 2020 just creeping ahead to 3.5% in 2020. That represents a decline of 0.1% from the WEO April projections for both years.

IMF Global Growth

Figure 1: Global Growth Outlook     Source: IMF October 2019

After a severe slowdown in the last three quarters of 2018 and the first half of 2019, the pace of global economic activity remains weak. What is quite apparent is that there has been a global contraction in manufacturing activity and business confidence. That has dipped lower to a level not seen since the height of the global financial crisis over a decade ago.

Naturally trade and geopolitical tensions have increased uncertainty about the size and scope of the global trading system. It is also clear that international cooperation is no longer guaranteed. Given the frustrating outlook, doubts are beginning to rise that the standard textbook answers as to how to solve a recession will not work in the near future.

One reason for the sense of despair is that the worlds leading central banks, forced by a political failure to provide a “Keynesian” fiscal stimulus have provided a flood of easy money through low, even negative interest rates and asset purchase schemes.

Why, in 2012 such actions were described by Mario Draghi, the President of the European Central Bank (ECB), as a measure to save the Euro, July 26th, 2012

“…we think the Euro is irreversible. And it’s not an empty word now, because I preceded saying exactly what actions have been made, are being made to make it irreversible. But there is another message I want to tell you.

Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough. …”

By lowering the cost of capital to developed world governments and with constant credit spreads to lower credits one could argue that we have lived through a period when the lines of fiscal and monetary policy have been blurred if not merged. Even if the was political pressure applied to so called independent central banks at least the financial system was saved from a meltdown.

However, we have now begun to realise that the super accommodation has created a new series of problems. Draghi himself said:

“…The negative side effects as you move forward are more and more visible. …”

Negative rates serve to disable the money-making ability of a nations banking system which in turn hurts the economy. Bank earnings are so low that the iShares EURO STOXX Banks 30-15 UCITS stands at 8.91, the lowest level in 9 years.

iShares Banks

Figure 2: the iShares EURO STOXX Banks 30-15 UCITS   Source:

This negativity around the banking sector reflect a view that the era of super accommodation has simply undermined the basis of competitive capitalism. It is suggested by hawkish, hard-money disciplinarians that the significance of quantitative easing (QE) and the other policies that have eroded the pillars of strength that a market economy is built open. We are, in fact living in a new era of economic exploration as we have yet to grasp or comprehend how significant the distortion may be.

The next two charts illustrate how uncertain the general economic outlook is. In Figure 3, I show the path of the yields of key European 2-year sovereign debt. I accept that the UK is priced in £ not €, however, it serves as useful gauge of Brexit uncertainty.

2 Yr Yields

Figure 3: European 2-Year Yields   Source: Bloomberg and Spotlight Ideas

One can see how the Italian and Spanish spreads were posing a risk to the Euro In 2012. The markets could have really tested the resolve of the CB by probing where the backup buying commitment really lay. Instead they saw the ECB as being the buyer of last resort and bought paper and enjoyed the price appreciation that eschewed.  

Italian paper did see yields screech higher in May 2018 when the former coalition party “The League” called for a wave of more spending. However, as they are not in government now, Italian yields have calmed down.

The next critical chart, (Figure 4) is that of the U.S. 2-10 spread. Historically that has, when below 1% or 100 bps been a forerunner of a recession. Do not forget the U.S. recovery is now a decade long and certainly feels ripe for a correction.

Why so?

I accept that the advent of cheap money as a solution to the huge distress of the financial crisis in 2007 and 2008 was essential in size and scope for providing needed liquidity. However, the persistence of such low rates, ten years on has served to engineer a serious set of systemic consequences.

The western economies are now fundamentally less competitive and the great distortion has allowed wealth and the means of investment to stay pooled in the very institutions that are seen as the cause of so much financial instability.

US Treasuries

Figure43: U.S. Treasury 2/10 Year Spread (bps)     Source: Bloomberg and Spotlight Ideas

Equities have risen as cash rich corporations have cashed cash rich corporations, service companies, in effect, anything that is light on fixed assets. However, cash is a current asset and so as revenue falls so metrics such as return on assets declines, so the answer id to buy up shares. This is worrying as the very same exercise happened in Japan in the mid to late 1980’s.

What can we do?

The initial challenge is to identify what and how QE has done to distort the real economy. It appears to have a much-needed rescue measure that stayed in place well beyond its sell by date.

The market may have had a tantrum, but the central banks should have realised that the punch bowel needed to be rationed, if not taken away. I admit I supported the first wave of QE; however, I have argued for its gradual neutralisation as far back as 2015. It is no longer a low-cost option. It is a dislocating distortion that has seen loose money simply circulate within the banking system and the major corporation. There has been scarce evidence of a “trickle down” to SME’s or individual households.

In effect the central banks have helped create a self-serving closed system. One that is not inflationary. Even if the banks are enjoying a better level of capitalisation, the distorted yield curves of the U.S. and Europe have failed to spark a new wave of lending.

What the banks should have done and should still do is write down much of their unsecured debt.

Instead easy money for the banks has not corrected a weakness in the system that forces the banks to scrub clean their balance sheets. Use the easy money to write off impaired assets. Free an indebted public of their crippling obligations but place the uncreditworthy on strict watch lists that will prevent such a build up of unmanageable debt again.

Is it any wonder that macroeconomics feels discredited? Indeed, only three of the last 10 Nobel prizes in Economics have gone to macro. The fact that low, even zero rates have not delivered an economic recovery means that there is much talk of a new raft of ideas in macroeconomics being needed.

The large-scale version of the social science appears to have missed the opportunity to recognise the weaknesses in the global economy before the financial crisis. The models have not developed to include financial vulnerability. Assumptions about human behaviour and how markets operate have been missing the reality target for some time now and so undermined the effectiveness of macroeconomics as a guide for practical policy making.

Central bank and academic macroeconomists need to rework how they understand the economic forces that shape peoples’ lives and to influence policy transforming macroeconomics back into a useful policy and respected science that is relevant for our current needs.

That means mounting a challenge to the central assumptions and current methods so that new building blocks that answer the need to create a new boost to business confidence, investment decisions, and global trade.

Macroeconomic Strategist

Stephen Pope is the Managing Partner of Spotlight Group. He has worked in the world of finance since 1982 and has performed d... Continued

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