With the global economic downturn in full swing, one of the burning questions on everyone’s minds is who will be the first central bank to take interest rates to zero and how close will everyone else get?
We are in a global easing cycle and the varying aggressiveness of central banks around the world means that any country could be the first to see zero interest rates.
We expect December to be another active month for the foreign exchange market as central banks around the world take their interest rates to historically significant levels. There are 4 central banks with monetary policy decisions in the first week of December and all 4 are expected to cut interest rates. The closest to zero is the Bank of Japan, but having been there before, they are reluctant to revisit those levels. The US Federal Reserve and the Swiss National Bank have the second lowest interest rates. Both central banks are expected to continue to ease, but the Fed has been far more open about going to zero interest rates than the SNB. Realistically, Japan and the US will probably be the only ones to take rates all the way down to zero. Switzerland should be left with the second lowest interest rate when the dust settles followed by the Bank of England.
What Happens After Zero?
When a central bank runs out of room to cut interest rates, they resort to Quantitative Easing. This term was coined by the Bank of Japan in 2001 when interest rates were already at zero and the central bank stopped targeting the overnight call rate and turned to targeting a current account level. Their goal was to flood the Japanese financial system with liquidity by buying trillions of yen of financial securities including asset-backed instruments and equities.
It can be argued that the US has already engaged in Quantitative Easing as the government has recently announce plans to spend $800 billion to unfreeze the consumer and mortgage market. They have agreed to buy mortgage backed securities backed by government sponsored entities and could accelerate that if interest rates hit zero. Excess reserves have also increased significantly, driving the effective fed funds rate well below 0.5 percent. This would have been one of desired outcomes of quantitative easing. Last week, Fed vice chairman Donald Kohn said quantitative easing measures were under review at the central bank as normal contingency planning. The goal would be to encourage banks to lend more aggressively by coming in as a buyer at specified rates. Even though quantitative easing drove Japan into deflation, it was the key to turning around the economy and this is a risk that the US central bank may have to take.
Here’s where the major central banks stand and what is expected for the next meeting:
Federal Reserve – 50bp Cut Expected on 12/16
On October 29, the Federal Reserve took interest rates to 1 percent, which is near the record low reached in 2003 and 2004. While other countries have just started reacting aggressively to financial conditions, the Fed has been mounting cuts as far back as the middle of 2007. There has been no looking back since, as rates have been cut 425bp since 2007 and 250bp year to date. With interest rates near ultra low levels, the Federal Reserve has already resorted to unorthodox policy tools. More easing is expected with the markets torn between a 50 or 75bp rate cut in December. The FOMC statement will be particularly important this time around because the Fed will have the difficult decision of signaling a move to zero interest rates. In order to deal with this decision, they have expanded their monetary policy meeting from 1 to 2 days. Fed Chairman Ben Bernanke has remained dovish throughout the past few months which mean that another rate cut is practically guaranteed.
European Central Bank – 50bp Cut Expected on 12/04
On November 6, the European Central Bank cut interest rates by 50bp to 3.25 percent. The European Central Bank has abandoned their old monetary policy metric in the previous months, opting for a more growth-concentrated approach to interest rate decisions. Such a change has accompanied a round of rate cuts that has brought the target rate down to 3.25%. ECB President Trichet has made no indication that rate cuts would stop here. However, in relation to neighboring nations, the ECB has not acted as aggressively, dropping rates only by 75bp this year. Compared to a year to date cut of 250bp by the US and 225bp by the UK, the ECB seems to be lagging behind the curve. Now that the region has officially hit a recession, it is possible that they will be more aggressive in easing rates. The ECB has the power to organize a continuous program of such policy implementation since their target rate is one of the highest, outside of Australia and New Zealand. The only factor holding them back is inflation pressures. Although producer and consumer prices have been easing, the central bank is not entirely convinced that the upside risks to prices have alleviated.
Bank of England – 100bp Cut Expected on 12/04
The Bank of England has been the most aggressive and proactive of the G-10 central banks in their attempts to ease monetary policy. The most recent cut of 150bp was a huge surprise to all traders and represents the largest single meeting cut to occur for any of the major central banks during the financial crisis. However what was even more shocking was the fact that the minutes from the most recent monetary policy meeting in early November suggested that they considered an even larger interest rate cut. Going into the December monetary policy decision, the market expects the BoE to ease by another 100bp. With the economy in a recession according to UK officials, interest rates could fall as low as 1% if the crisis continues well into the New Year. The BoE’s ability to cut by such a sizable amount was also reflected in the fact that inflation, once the primary concern, has eased considerably in the last few months. In addition to monetary stimulus, the UK government has been at the forefront of bank bailouts and fiscal stimulus.
Bank of Japan – No Rate Cut Expected on 12/19
After cutting interest rates by 20bp last month’s meeting, the Bank of Japan left interest rates unchanged in November. It is unlikely that we will see much more easing as officials have expressed a certain sense of reluctance in bringing rates back to zero. The Japanese are all too familiar with the implications of such rates and will be forced to look for new methods to ease the financial strain on the country. Masaaki Shirakawa, the BoJ Chairman, informed the Bank’s staff to, “swiftly examine and report possible changes in the treatment of corporate debt as collateral, as well as possible ways to enhance flexibility in funds-supplying operations collateralized by corporate debt.” Such statement seem to indicate that, while we will unlikely see much in the way of new rate cuts, we will see new initiatives that focus on shoring up lending and improving liquidity.
Bank of Canada – 50bp Cut Expected on 12/09
On October 21, the Bank of Canada cut interest rates by 25bp to 2.25 percent, the lowest level since October 2004. Although the size of the rate cut was smaller than the market had anticipated, the BoC had already cut interest rates by 50bp on October 8th. Mark Carney, the Governor of the Bank of Canada, has been very vocal in explaining his thoughts on the health of the Canadian economy. Carney comments can be summed up in this statement, “the risks to growth and inflation in Canada appear to have shifted to the downside…some further monetary stimulus will likely be required to achieve the inflation target over the medium term.” We can rarely expect such a “cut and dry” statement from a central bank official. He leaves little to question. However, he does note that the economy does have some strong areas, specifically domestic demand (retail sales rose 1.1 percent in the month of September). The BoC governor also noted that the weakness in the Canadian dollar has picked up some slack from the declines in international demand. The market expects the central bank to ease interest rates by another 50bp at the next meeting, which would take rates down to 1.75 percent. Canadian interest rates have not been below 2 percent since the 1960.
Reserve Bank of Australia –100bp Cut Expected on 12/02
The Reserve Bank of Australia has definitely not sat idly by watching its economy deteriorate. Along with 175bp of easing this year, the central bank has also resorted to intervening in the currency markets to support its currency. Intervention has been a very controversial monetary tactic because it simply does not have a good record. However, such desperation does indicate that the bank is having a tough time dealing with the consequences of rate cuts. A target rate of 5.25 percent leaves the RBA with plenty of opportunity for additional easing in the future. However, the RBA minutes explain that the 75bp cut made at the last meeting would be necessary in that “there was an advantage in moving the setting of monetary policy quickly to a neutral position.” Regardless of such a statement, the market still believes that the RBA will cut interest rates by 100 to 125bp at the December meeting.
Reserve Bank of New Zealand – 150bp Cut Expected on 12/03
The Reserve Bank of New Zealand cut interest rates rates by a full percentage point in October, citing “ongoing financial market turmoil and a deteriorating outlook for global growth. In a statement published in an article released by the RBNZ, the bank notes that “global developments have proven extremely disruptive and it will likely be some time before financial market conditions normalize. The Bank will continue to adopt measures as needed to maintain the stability of our financial system as far as possible in these difficult times.”Once again we see some very dovish statements made explicitly from central banks. The recession embattled country has plenty of ammunition as rates are at the very high level of 6.50%. While zero percent interest rates may not be a possibility, it is possible that we will be surprised by some extremely aggressive cuts. The market currently expects the RBNZ to cut as much as 1.5 percentage points in December and eventually take interest rates down to 5 percent. It is also important to note that rates have not fallen below 4.50% in the last ten years.
Swiss National Bank – 50bp Cut Expected on 12/11
The Swiss National Bank surprised the market by delivering a full percentage point intermeeting rate cut. Citing the obvious fact that international economic conditions have worsened, the central bank made its largest one day rate change in eight years. The economy has weakened substantially due to the fact they have a large exposure to the banking sector. The Swiss National Bank hopes that the move will provide the market with a generous and flexible supply of liquidity. The bank’s continuous issuance of surprise rate decisions leads us to believe that more can be expected. Many economists expect the SNB to continue cutting interest rates to 0.5 percent.