[Lee Jong-woo's Economic Reading] The Interest Rate Cut Card Revisited, Effect Wears Off... Time to Use Fiscal Policy

US Interest Rate Cut Expectations Surpass Predictions... Suspicions Grow of Unknown Risks as Impact Exceeds Financial Crisis
No 'Cut' Effect in Real Economy... Only Costs Remain Instead of Positive Impact

As the novel coronavirus disease (COVID-19) was expected to slow down the economy, the U.S. Federal Reserve (Fed) cut its benchmark interest rate by 1.5 percentage points in March alone. Having maintained low interest rates for 11 years since the financial crisis and achieved considerable success, it is natural to bring out the rate cut card again.

The U.S. rate cuts have lowered market interest rates in advanced countries again. The yield on Germany's 10-year government bonds fell to -0.5%, meaning that if you buy German bonds now, you will not receive any interest payments for 10 years and will get back less than the principal at maturity. The situation in the U.S. is similar. The 10-year Treasury yield once dropped to 0.3%, falling below the previous low of 1.3%. In the past decade, U.S. interest rates approached 1.3% twice: once in 2011 during the height of the European debt crisis, and again in 2016 when the United Kingdom decided to leave the European Union (Brexit). Seeing that rates are now lower than those times, the bond market seems to view the current U.S. economic situation as worse than during the European crisis.

While this decline in interest rates is interpreted as investors moving in anticipation of rate cuts, there are suspicious aspects. This is not the first time the Fed has lowered the benchmark rate to 0.25%. From 2009 to 2015, the rate was maintained at a similar level, but market rates did not fall below 1% then. Only this time have rates dropped to the low 0% range, making it difficult to attribute the rate decline solely to the Fed’s cuts. The market is more worried about the possibility of a significant global economic slowdown due to COVID-19 than about the rate cuts themselves.

The previous two U.S. rate cuts were larger than expected. In December 2007, just before the financial crisis, Bear Stearns, one of the five major U.S. investment banks, became insolvent. As the risk of crisis increased, the Fed cut the benchmark rate from 4.25% to 3%, a 1.25 percentage point reduction. In October 2008, when the financial crisis began with the bankruptcy of the global investment bank Lehman Brothers, the rate cut was only 1 percentage point. This time, the Fed cut rates by 1.5 percentage points within 15 days. The much larger and faster rate cuts compared to the financial crisis led people to suspect that some unknown risk had emerged in the U.S. financial and credit markets.

This suspicion caused polarization in interest rates. Internationally, emerging market rates rose while advanced country rates fell simultaneously. As a slowdown due to COVID-19 was expected, investors sold emerging market bonds and bought advanced country bonds. Within the U.S., polarization appeared between government bonds and corporate bonds, especially high-yield bonds with low credit ratings. U.S. corporate bonds issued by energy companies with low credit ratings amount to about $120 billion. These companies need oil prices to exceed $50 per barrel to make a profit, but current prices are far below the break-even point. As losses became inevitable due to falling oil prices, U.S. high-yield bond yields exceeded 10%. There is concern that the energy sector default rate, which was only 1.3% in 2014, could rise to 14% again as oil prices fall. Just as the financial crisis started with subprime mortgage bad debts, there is growing fear that bad corporate bonds, repackaged as derivatives, could negatively affect various bond funds. This is why the Fed has actively cut rates.

So, will cutting rates solve the problem? The Bank of Korea cut rates twice in the second half of last year, and the Fed cut rates three times. It has already been nine months since the first cut. It is time for the rate cuts to have an effect on the real economy, but consumption and investment remain sluggish with no noticeable change. The stock market is even worse. Unlike in the past when the Fed’s monetary policy tightening led to stock prices rising more than 70%, last year’s rate cuts only raised stock prices by 20%. And a bigger problem occurred during the March cut. Despite the sharp rate cut, stock prices fell by more than 30%. Rate cuts are no longer effective in either the real economy or financial markets. Until the beginning of the year, the market believed in the effect of rate cuts. Even if stock prices fell, there was a belief that rate cuts would restore normalcy. This belief naturally arose from the long period of low interest rates, but now it is losing its power. For rate cuts to be effective, the policy must be temporary. This standard has been broken, so low interest rates are no longer playing a significant role.

The positive effects of low interest rates have now disappeared, leaving only costs. First, asset prices. In recent years, stock and real estate prices in advanced countries have risen significantly. Low rates meant borrowing costs were low, which helped push prices up. Now that prices are falling, the effect of reduced costs has disappeared, leaving only the fear of decline. Even if interest costs are only 0.1%, a 5% drop in prices means the real cost exceeds 5%. Since asset prices are high, even a slight external shock can cause prices to fall, increasing downward pressure significantly.

Another problem is the increased dependence on rate cuts. Due to the prolonged low interest rates, whenever the economy worsens slightly, there are demands for rate cuts. Central banks are not hesitant to lower rates. While it would be fine if rates could be continuously lowered, this is physically impossible because nominal rates cannot fall below 0%. The greater the demands on policy, the higher the risk of overreach.

The economy’s self-sustaining power has also weakened, a legacy of low interest rates. When low rates persist for a long time, the economy tends to rely on policy rather than solving structural problems on its own. Companies are no exception, making them less resilient to external shocks.

When the 2008 financial crisis occurred, the market worried that a phase might come when there would be no cards left to play and only declines could be watched. That state has now arrived. No advanced country currently has monetary policy tools left to use. Although the U.S. announced a quantitative easing plan worth $700 billion, it failed to attract market attention. Once monetary policy is exhausted, fiscal policy must be used. Although there are concerns about fiscal deficits, now is not the time to worry about that. We also need to first increase the supplementary budget size and consider disaster basic income for low-income groups and small business owners.

This content was produced with the assistance of AI translation services.