Financial Repression, Central Bank Indecision, Recession, and Stagnation

Commentary, Economy, Ian Madsen

‘Financial repression’ is a term referring to governments or central banks, such as the Bank of Canada or the U.S. Federal Reserve Boar., intervening in financial markets to suppress interest rates [1]. Central banks have been intervening for nearly two years, causing a serious disruption in the financial markets.

To illustrate, the official rates of the Bank of Canada [2] and the Federal Reserve [3], are 0.25 and 0.08 percent, respectively, whereas the twelve-month inflation rates were 5.1 [4] and 7.5 percent [5], in January, 2022. In both Canada and the U.S., the central banks were buying government bonds.  This action lowered longer-term interest rates and is called ‘quantitative easing’ (QE). It is, in effective, a debt monetization process. [6] In other words, central banks ‘print’ money to pay for the services they provide.

It is obvious that citizens are losing money in this process even after inflation is taken into account. Without QE, interest rates are normally close to, or higher than, the inflation rate. When QE was not used, as in the 1970’s, interest rates were near the prevailing inflation levels.

Recently, both the Bank of Canada [7] and the Federal Reserve [8] say they are ending QE by not buying more bonds. As a result, the central banks are making long term debt more costly, as other buyers must now buy the bonds and they demand higher interest rates to do so. As well, both central banks [9] say they will raise short-term interest rates. [10]

Why this matters, of course, is because a relatively small increase in the interest rates for bonds, especially when the rates have been very low, will have a very large effect on the prices of all assets; not just government bonds, but real estate and share prices too.

Bond investors and traders use a calculation called ‘the bond duration,’ [11] that is the present value of the interest paid on those bonds, usually paid semi-annually, and the final principal paid out when the bonds mature. For U.S. 10-year Treasury Notes yielding 1.875 percent now [12], the duration is about 9.5 percent, [13] which means that a one percent increase in interest rates will result in nearly a 10 percent decrease in value. For 30-year Treasury Bonds, the sensitivity is about 22 percent.

Of course, the stock and real estate markets, and mortgages, are extremely sensitive to changes in interest rates. Notably, the Bank of Canada overnight interest rate was 1.75 percent two years ago [14] and it is 0.25 percent today. Were interest rates to return to the level they were two years ago, already a historical low, the rates would rise by about 1.5 percent for short-term bonds and likely higher for long-term bonds.

If this happens, the bond markets could decrease by over 30 percent (1.5% x the duration of 22). Stock markets would not be immune to this increase either. In fact, the changes that central banks have been making have already affected stocks in companies, such as Shopify, Meta, and Tesla. Yet investors still do not seem to realize how badly things could change [15] over the next few years.

If government policy does not change, future home buyers may not be able to qualify for mortgages, which will result in lower demand for housing. Existing home-owners will then need to refinance their mortgages at higher rates. Also, firms will likely reduce investing in their businesses and be less likely to hire more employees. When interest rates peaked in 1981, for example, a severe recession occurred and unemployment exceeded 10 percent [16].  Unfortunately, thousands of businesses did not survive that recession. Similar to that period, the central banks are now playing catch-up, having to raise their rates dramatically to match the rate of inflation.

Thus, the failure of central banks to end QE much sooner and begin raising interest rates, may be very costly to all consumers. If we are lucky, the next few months may only bring stagnation and not a full-blown recession, but the odds are leaning towards the latter.

Ian Madsen is the Senior Policy Analyst at the Frontier Centre for Public Policy.

 

  1. https://mises.org/library/meaning-financial-repression
  2. https://www.bankofcanada.ca/core-functions/monetary-policy/key-interest-rate/
  3. https://www.federalreserve.gov/releases/h15/
  4. https://www.theglobeandmail.com/business/article-canadian-inflation-hits-a-new-three-decade-high-with-pressure-to-raise/
  5. https://www.cnbc.com/2022/02/10/january-2022-cpi-inflation-rises-7point5percent-over-the-past-year-even-more-than-expected.html
  6. https://corporatefinanceinstitute.com/resources/knowledge/economics/quantitative-easing/
  7. https://www.cbc.ca/news/business/bank-of-canada-decision-1.6226796
  8. https://www.morningstar.com/news/marketwatch/20211215541/fed-moves-to-end-bond-buying-by-march-eyes-three-rate-hikes-in-2022
  9. https://www.cnn.com/2022/01/26/economy/federal-reserve-powell-policy-update/index.html
  10. https://www.theglobeandmail.com/business/article-bank-of-canada-interest-rate-hike-announcement-explainer/
  11. https://www.cfajournal.org/duration-bond/
  12. https://www.wsj.com/market-data/bonds?mod=nav_top_subsection
  13. https://dqydj.com/bond-duration-calculator/
  14. https://www.bankofcanada.ca/rates/interest-rates/money-market-yields/
  15. https://www.theglobeandmail.com/investing/markets/inside-the-market/article-why-rising-real-interest-rates-threaten-the-equity-market-rally/
  16. https://www.cbc.ca/archives/entry/unemployment-reaches-all-time-high-in-1982