ZIRP is the acronym for zero-interest rate policy, currently being followed by many central banks. For better or worse, the central bankers have backed themselves into a corner. My forecast is the forever ZIRP. Read on.
Background
On June 4 the IMF urged the Fed to postpone raising interest rates until 2016. I’ll have more to say about that later in this article. The thrust of this article, however, is a forecast: The Fed’s Board of Governors has backed itself into a corner. They will be forced to keep interest rates at zero virtually forever. This also applies to other major central banks, including the European Central Bank whose gurus recently announced a negative interest rate policy. (Japan has a head start, having implemented ZIRP years before the Fed and ECB caught up.)
IMF Director-General Christine Lagarde
Who Owns the Bank?
There’s an old saying among bankers: If you have a small loan the bank owns you. But if you have a really, really big loan, you own the bank. Apparently this no longer applies to your friendly local banker. Central banks are now owned by their biggest borrowers: national governments.
The Board Of Governors: Chair Janet Yellen, Vice-Chairman Stanley Fischer, Jerome H. Powell, Daniel K. Tarullo, Lael Brainard
Let’s look at the latest data for the U.S.[1] At the end of 2014 the gross federal government debt was $17.8 trillion. Net interest paid on this debt was $0.23 trillion. The implied interest rate was a whopping 1.29%.
Suppose the Fed raises interest rates by, say, 200 basis points. Assume that increase is passed through to the interest rate paid by the government.[2] The interest rate will be 3.29%. And interest payments on the government debt will become $0.58 trillion.
“So what?” you ask. To put this in perspective the total government budget deficit in 2014 was $0.48 trillion. In other words, a two percentage point increase in the interest rate would double the federal government budget deficit.
And now we can see the real danger of the persistent, large deficits the government has run under the Obama administration. That new debt does not vanish at the end of each year. It accumulates. Effectively, the federal government owns the Federal Reserve.
As always, my methods are transparent. Click here to download the Excel workbook and play with your assumptions.
Why Did the IMF Caution the Fed?
The U.S. government is not alone. There are many other governments with government debt to GDP ratios over 100 percent. Each and every one of those governments is holding their central bank hostage. The lone exception is the ECB which does not technically have a single government to which it reports. Until recently, the ECB has shown little sympathy to the plights of Greece, Spain, Italy, and Portugal. But a negative interest rate policy is a subsidy to every government that is part of the eurozone. The IMF is simply trying to postpone the inevitable.
Conclusion
Decades ago I was privileged to learn monetary theory from Dr. Karen Johnson. She warned us of the dangers of running federal government budget deficits when the economy was reasonably healthy. Her main concern was what the government would do if the deficit was already large and the economy slipped into recession. Even with her intelligence, I doubt she forecasted how badly various governments have messed up their budgets.
[1] Economic Report of the President, 2015, Table B-22. Excel file can be downloaded from this link XLS. Accessed June 5, 2015.
[2] In practice, this will take some time due to the term structure of the U.S. government debt. T-bills will be affected almost immediately. But T-bonds will take quite a bit longer to be refinanced. As an economist, of course, I know this is irrelevant because the true cost of borrowing is the opportunity cost.
