The US Fed and the People’s Bank of China cut rates this week and we will follow next week, along with the European Central Bank.
Overnight, US third quarter economic growth contracted as consumers stopped spending, hinting at a long and bitter slump. The AMP’s Dr Shane Oliver sees more cuts to come as a result.
The decline in global interest rates is continuing with the US Federal Reserve announcing another 0.5% reduction in its key Fed Funds rate to just 1% and China cutting its benchmark lending rate for the third time in two months.
While interest rates have declined significantly in the US, from last year’s peak of 5.25%, they have fallen far less in other countries as indicated in the chart below.
Our assessment is that interest rates in most countries are set to fall significantly further, probably taking them back to the lows reached earlier this decade or even lower.
Reasons why interest rates will fall further
There are several reasons why interest rates are set to fall a lot in most countries:
Firstly, the threat to global economic growth is now looking even more serious than was the case earlier this decade.
Even prior to the turmoil in September and October leading indicators (which are basically economic indicators that lead future economic growth, such as measures of confidence) for the G7economies were pointing to a recession at least as bad as that seen earlier this decade. See the next chart.
However, since Lehman Brothers was allowed to go bust in mid-September, triggering a further loss of trust amongst banks and other financial institutions, the financial crisis has taken another turn for the worst leading to a further tightening in credit flows, a further loss of business and consumer confidence and of course a further sharp fall in share markets and wealth.
Furthermore, the crisis has now spread to a range of emerging countries, via lower commodity prices in the case of some and capital flight.
This has been all made worse by the guarantees on bank borrowing in developed countries.
Recent data has confirmed that even China is looking a lot weaker. As a result, the outlook for global growth has deteriorated further over the last two months.
In fact, it now seems likely that the recession in the developed world that probably started in the June or September quarters this year will last a year or so and the slowdown in the emerging world will now be sharper than previously expected.
Secondly, the collapse in global growth will lead to excess capacity and this, along with the slump in commodity prices since mid year, will lead to a sharp decline in inflation pressures.
If anything deflation is likely to return as a worry next year or in 2010, particularly with excess capacity in China’s export focused factories likely to rise significantly.
Thirdly, the credit crunch has had the effect of pushing up the level of private sector borrowing rates relative to official cash rates and government bond yields. While the situation is improving in money markets, adding to confidence a complete meltdown or long and deep recession is not on the way, they are still a long way from normal and credit markets are likely to remain difficult for some time.
To reduce private sector borrowing rates to a given level it will be necessary to cut official interest rates by more than normal.
For example, in Australia’s case the gap between the mortgage rate and the cash rate is now around 0.5% greater than was the case earlier this decade.
Finally, normally in an economic downturn the yield curve (the gap between 10 year bond yields and short term cash rates) needs to become steeply positive.
In other words, short term borrowing rates need to fall well below long term expected returns to encourage investors to borrow.
In a banking crisis it’s even more important that the yield curve become positive because banks borrow short and lend long, so a positive yield curve helps strengthen the financial position of the banks.
In the US the yield curve is quite steep already (i.e. +2.8%) but normally it becomes even steeper in an economic slump.
In Europe the yield curve is still flat to slightly positive and in Australia it is actually inverse, with the cash rate still above the bond yield.
So cash rates still need to fall a long way.
Further rate cuts
The bottom line is that further interest rate cuts are necessary and likely over the next few months:
- US interest rates are likely to reach 0.5% or lower;
- The European Central Bank has signalled further rate cuts ahead, with another 0.5% cut likely next week and they are likely to fall at least as low as their 2003 low of 2%. UK rates are likely to fall to the same level.
- The Bank of Japan is likely to take rates back towards zero given the growing severity of its recession.
- Rates are likely to head lower across Asia, including China as the focus shifts from inflation to growth.
What happens when interest rates hit zero?
As interest rates get close to zero there will be much debate about what next. As indicated by Fed Chairman Ben Bernanke back in 2003, there is still much that a central bank can do including resorting to the printing press (ie, printing money).
While the latter won’t be undertaken lightly, it should not be seen as inflationary if people are not responding to low interest rates and hence not spending.
What about Australia?
Australian growth is likely to sl
