Very low rates mean there is little room to maneuver if economic conditions get worse.
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The development with the most profound signal about the future of the global economy has not been the steep drop in the stock market over the last week. Instead, it’s what has been happening in the bond markets.
Global interest rates are plunging. Partly this reflects the general rush to safe investments that takes place whenever the world economy looks dangerous. But it also reflects expectations that the Federal Reserve and other central banks will cut interest rates or take other action to try to contain the economic damage of coronavirus.
That amounts to a powerful and pessimistic warning about the world economy in years to come. And that warning remains valid even if the economic damage from the coronavirus epidemic turns out to be mild and short-lived.
The yield on the benchmark 10-year United States Treasury bonds fell to a record low of 1.16 percent in trading Friday morning, down from 1.9 percent at the start of the year and 2.7 percent one year ago. From Japan to Germany to Australia, every other major economy is experiencing a similar shift.
Usually longer-term interest rates fall to very low levels only at times of financial panic and recession. But currently, the economy is in sound shape and investors are seeing only the threat of economic disruption rather than the reality.
It is the financial markets’ way of saying that the Fed and other central banks will need to keep rates exceptionally low indefinitely — that the era of cheap money not only isn’t over, but is only beginning. And that leaves the world economy all the more vulnerable if things were to really take a turn for the worse.
“If this is a severe shock, they don’t have the ammunition to deal with it,” said Joseph Gagnon, a senior fellow at the Peterson Institute for International Economics. He has argued that the Fed has the capacity to offset only a mild to moderate recession, given the low level of interest rates even before the latest pandemic fears.
If just the threat of coronavirus is enough to push rates below their lowest levels during the global financial crisis of a decade ago or the Great Depression, that means central banks are likely to find themselves desperately short of ammunition if the virus, or some other future setback, causes real economic disturbance rather than just the fear of it.
Look at it this way: One year ago, the short-term interest rate that the Fed uses to guide the economy was above 2.25 percent. Last summer and fall, as trade wars and a slowing global economy appeared to threaten the American economy, the Fed cut that rate three times, to its current level of just above 1.5 percent. It seemingly worked.
Today, with major negative economic consequences of the coronavirus looking increasingly likely, futures markets indicate that investors expect two or three further interest rate cuts this year.
There’s a debate underway among economists and market watchers over whether such moves are wise.
The Fed’s interest rate tools are poorly suited to protect the economy from shutdowns in production resulting from disease fears. Economists can’t invent a vaccine or slow disease transmission rates. On the other hand, you go to war with the recession-fighting tools you have, not those you might wish to have.
But assuming the central bank indeed cuts interest rates to try to buffer the economy from damage, it would find itself with interest rates of around 1 percent or lower, in an economy that is doing quite well, for the moment at least.
That leaves little room for further stimulus through that conventional tool. Even a mild downturn would mean the Fed would be looking to less conventional tools, including the quantitative easing policies used extensively from 2009 through 2014, and sending more explicit signals about its intention to keep rates low far into the future.
The United States, essentially, would look even more like Japan and Europe, where interest rates have fallen into negative territory and stayed there for years. In Germany, the 10-year government bond yielded negative 0.55 percent Thursday; in Japan it was negative 0.12 percent.
To be clear, conditions are hardly dystopian in Western Europe or Japan. Countries can maintain high living standards and decent job markets even with the low-growth future that Treasury bond rates are implying.
The combination of low interest rates and large-scale deficit spending by the federal government has been enough to keep the United States growing for more than a decade, and has pushed the unemployment rate consistently below 4 percent.
But it raises a crucial question: If it took all this to achieve that continued growth, what would it take to deal with an actual economic crisis? The latest news developments around coronavirus, and the bond market moves in response, suggest we’re about to find out.
