Negative Interest Rates and the Business Cycle
The major way interest rates impact the business cycle is through stimulating or suppressing real estate. This is pretty clearly what happens if you look at the data in Ed Leamers paper Housing is the Business Cycle.
Mr. Leamer says as much:
“For long-run growth, residential investment is pretty inconsequential, but for the wiggles we call recessions and recoveries, residential investment is very very important.“
It’s stunning how huge Real Estate is in determining the business cycle – essentially all of the business cycle is due to residential investment.
An aside: The terrible truth is only a smallish amount of real improvement in our quality of life comes from housing, especially over the last 50 years. Yes, nicer houses are better, but we’ve already garnered most of the gains we will ever get from housing, at least here in the US.
Given the outsided (current) impact on housing on the business cycle, we have to start thinking through ways to get housing moving, at least until we can figure out a way to decouple the business cycle from residential investment.
Will negative interest rates impact mortgage rates? My initial guess is “less than you would think”. The reasons for this is pretty simple – potential real estate losses still swamp gains to be had from lending, these losses are very large around zero rates, and the expectations would be for rates to go to zero or above zero as soon as possible.
My strong belief is that interest rates do impact mortgage rates in normal times. In fact, the reason monetary policy work is real estate lending and borrowing is extremely interest rate sensitive. Real estate lending is far more interest rate sensitive than building a new factory, because the IRR required on a factory is so much larger than just a few percent. Businesses need to make 20% plus even to consider the plant viable, so adding or subtracting a few percentage points on the real estate loan isn’t going to change the “go/no go” decision that much. In fact, if a few % in lending does impact the decision, most decision makers would treat this as a red flag for the project.
Yet despite the power of interest rates to set mortgage rate levels, there are problems with negative interest rates.
First problem is the negative sign, which almost nobody would consider to be a permanent or even long term situation. In the world of monetarism, expectations are said to play a key role. I do not think it is credible to think the fed would maintain negative interest rates for years and years. Neither would the market. Hence, the expectations would be for these rates to be normalized to zero or above zero as soon as possible. The result of the expectations baked into negative interest rates would be for little or no impact on mortgage rates by the channel espoused by monetarists.
Another problem would be losses from negative rates would be small compared to losses from defaults. For many years, defaults were not part of risk models used by banks, because typically the banks would be able to sell these houses at higher prices than the foreclosed price. The amount of losses from negative rates – say negative rates of a .25% – are small, small enough to be absorbed by the large banks.
And finally, we come to the third problem – which is really a combination of the two prior problems. If the expectations are that negative rates cannot last, then of course banks are going to be cautious about lowering mortgage rates.
But even more powerful to them is the threat of the losses – and small differences in what the market considers to be the discount rate make large differences at low interest rates.
The discount rate is how people value real estate – it’s the rate at which the future cash flows from real estate are weighted to add up to a present value. In general, this rate moves slowly, and it is not 100% connected to the current mortgage rates or interest rates.
The down and dirty equation for present value is: Cash flows/discount rate
A quick example using $100 and 3% gives a Present value of $3,333.33 For every $100 in yearly cash flows, a discount rate of 3% gives a Present value of $3,333.
If discount rates go down to 2%, the Present value goes up to $5,000, which is a gain of 1,666. As discount rates change, then of course the Present Value based on the discount rate goes up and down.
Low interest rate environments put banks in a bind. The current of the underlying collateral real estate is driven by discount rates which are not fully under their control. Lowering interest rates tends to make the discount rate go lower too, which drives up the value of real estate.
This also works in reverse, higher interest rates cause the present value of real estate to go down. And this is the problem banks face at low interest rates – small changes in the discount rate level cause large changes in the value of the collateral supporting the loans they make.
Banks will not want to be exposed to the cycle of lowering mortgage rates much more which has the result of driving up interest rate values. The expectation is negative interest rates will be reversed as soon as possible. This is because the expected reversion of rates to higher levels will tend to dampen the enthusiasm of banks to cut mortgage rates and also cut the associated discount rate.
So a good first approximation guess is negative interest rates will have less of an impact on mortgage rates than normal rate cuts, due to the inherent pressures a banks faces, and the lack of a large disincentive. Mortgage rates will not go down as much as during normal rate cut environments.
Since housing is the business cycle, it’s likely negative rates will not have as much positive impact on the economy as we would want or expect.
A few days ago, I posted about constraints and the economy. Right now, the economy is not constrained by the availability of lending, or by reserves, so programs designed to lower the constraints of lending or banking reserves are not likely to work well or even at all.