The Near-Zero Interest Rate Trap; If long-term rates rise to normal levels, banks holding government bonds would be de-capitalized—a disaster

July 29, 2013, 7:04 p.m. ET

Ronald McKinnon: The Near-Zero Interest Rate Trap

If long-term rates rise to normal levels, banks holding government bonds would be de-capitalized—a disaster.



The conventional critique of the Federal Reserve’s policies of near-zero interest rates and massive monetary expansion is that they risk kindling excess aggregate demand and high inflation. Yet inflation world-wide remains low, and some major trading partners of the United States, such as Japan and now China, are worried about deflation. China’s Producer Price Index fell 2.7% in June, the 16th consecutive monthly decline.Nevertheless, artificially low short- and long-term interest rates can still distort the financial system and hold the economy back. And modest increases in interest rates to more “normal” levels could lead to more investment without an inflation risk.

For an example of how near-zero short-term interest rates can inhibit private investment, consider a bank that accepts deposits and makes new loans of three-months’ duration. The traditional spread between deposit and loan rates is about three percentage points. With this spread, banks can lend to small- and medium-size enterprises, the so-called SMEs—making loans that carry moderate risks and higher administrative costs per dollar lent. To increase the safety of its overall loan portfolio, the bank can also lend greater amounts to larger, more established corporate enterprises.

However, as short-term interest rates are compressed toward zero, larger corporate borrowers find it more advantageous to raise money by selling short-term commercial paper directly to other corporations, pension funds and money-market mutual funds. This leaves smaller banks in particular with a riskier portfolio of loans to SMEs, and the need to raise more bank capital to support riskier liabilities—so they may instead shrink the size of their loan portfolios.

Also, smaller banks can’t easily borrow funds from other banks to lend out to companies when interest rates are near zero. These other banks aren’t inclined to lend their excess reserves for a tiny yield, especially in the presence of even a moderate counterparty risk. They will instead just hold excess reserves.


As interest rates fall, money-market mutual funds will buy highly rated commercial paper and other short-dated financial instruments. However, if short-term interest rates approach zero, these money funds fear “breaking the buck.” Even a small negative random shock to the mutual fund’s portfolio from a client failing to repay could jeopardize the fund’s ability to cover interest payments to depositors. This means that depositors might only get 99 cents back on each dollar invested. Sponsors of these money-market mutual funds, often banks, are paranoid about the reputational costs of breaking the buck—so they may either close them or limit new deposits to the funds.

Despite the difficulties in an ultralow interest environment in getting short-term financing, can’t larger, well-known corporations still get the investment funds they need by selling longer-term bonds?

The problem here is that as banks and other financial institutions get used to near-zero interest rates and accumulate low-interest bonds for some years, they end up in a trap from which escape is difficult. And this trap has negative implications even for corporations that seek direct, long-term financing.

The trap was revealed for all to see after Fed Chairman Ben Bernanke’s suggestion, in congressional testimony on May 22, that the central bank might slow down its huge purchases of long-term Treasury bonds and other long-term securities—purchases designed to keep long-term interest rates low.

Mr. Bernanke carefully hedged his statement. He said that certain preconditions of the economic recovery, notably a sharp fall in the unemployment rate to 6.5%, had to be met before tapering could begin. But markets ignored these caveats. Long-term interest rates rose from 1.5% to 2.5% in the U.S., and stock markets crashed around the world in the four days that followed.

A chastened—and trapped—Mr. Bernanke said in a June 19 press conference that money will remain easy for the foreseeable future. But the trap matters for the efficiency of the long-term bond market.

What have central banks wrought? As Andrew Haldane, a top official at the Bank of England, declared in June of his own institution, “the biggest government bond bubble in history.”

The Federal Reserve, the Bank of England, the Bank of Japan 8301.TO -2.73% and European Central Bank all have used quantitative easing to force down their long-term interest rates. The result is that major industrial economies have all dramatically increased the market value of government and other long-term bonds held by their banks and other financial institutions. Now each central bank fears long-term rates rising to normal levels, because their nation’s commercial banks would suffer big capital losses—in short, they would “de-capitalize.”

But the potential turmoil in bond values also makes it more difficult for corporations seeking to raise long-term financing. Indeed, bond-market dealers in the U.S. are currently paring their inventories because of the risks associated with high volatility.

In 2009, when the Federal Reserve initiated quantitative easing, the prices of bonds and equities rose as long-term interest rates fell so as to buoy the economy. Now, after a low-interest-rate “equilibrium” for some years, the potential for exiting its quantitative-easing program means high volatility in bond markets—a volatility that inhibits new bond offerings for domestic investment. Mr. Bernanke’s tapering speech illustrates how that can happen: New bond and equity issues are put on hold.

By trying to stimulate aggregate demand and reduce unemployment, central banks have pushed interest rates down too much and inadvertently distorted the financial system in a way that constrains both short- and long-term business investment. The misnamed monetary stimuli are actually holding the economy back.

The way out is for major central banks—the Federal Reserve, the Bank of England, the Bank of Japan and the European Central Bank—to begin slowly increasing short-term interest rates in a coordinated way to some common modest target level, such as 2%. Coordination is crucial to minimize disruptions in exchange rates. They should also phase out bond buying so that long-term interest rates once again become determined by markets.

Paradoxically, such modest increases in interest rates could actually stimulate investment and growth in all four economies.

Mr. McKinnon, a professor at Stanford University and a senior fellow at the Stanford Institute for Economic Policy Research, is the author of “The Unloved Dollar Standard: From Bretton Woods to the Rise of China” (Oxford University, 2013).

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (, the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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