The Uncertainty Paradox

by George Hatjoullis

Despite negative yields and interest rates investors continue to hoard bonds and cash. Why? Gillian Tett of the FT suggests it reflects a “…widespread, and profound, sense of uncertainty”. I concur. The irony is that the policy landscape is adding to, rather than diminishing, the uncertainty. Policy makers need to stop reacting through the conventional policy playbook and start thinking outside of the box.

Negative interest rates bother investors. They do not reassure. The idea of paying to have an entity borrow your money does not sit well with the prevailing psychology. It bothers both borrowers and lenders. There is a profound but poorly defined sense of ‘something is very wrong’ and this, paradoxically, increases the desire to hold safe, albeit negative yielding, assets. Monetary policy is adding to the demand for cash and risk free assets when its purpose is to increase supply (of money) and diminish demand.

Of course, as has been explained at length in these blogs, monetary policy cannot increase the supply of money. The loss of too-big-to-fail status of all banks means only insured deposits are really money. Any deposit amount above the insured is simply a loan to the bank with a status equal to that of senior bond holders. The amount of insured deposits is capped so therefore is the stock of money. Risk free bonds such as those issued by (some) governments offer better security for large deposits but governments have been reducing supply. Worse still, central banks keep buying the outstanding stock leaving yields hovering around zero.This bizarre situation is making investors nervous and more inclined to hold cash and risk free assets.

Equity and property investments, in contrast, offer comparatively high yields. It is not difficult to construct an equity or property portfolio yielding above 5%. This is a pretty good ‘risk premium’ compared to cash and bonds basically offering your money back if you are lucky. So why is more money not flowing into property and equity markets? In fact the money has so flowed and both are at or close to all time highs. There is a fear that these high yielding assets are nevertheless overvalued and primed for a fall. The fear is that the high yields cannot be sustained. This fear is being fed by the profound but ill-defined sense of uncertainty that prevails. Investors are in unfamiliar territory and their conventional playbook offers no guidance. The inevitable reaction is to play it safe. The same applies to real investment in infrastructure and production. It is cheap to borrow but is this the right time to invest?

The world needs more confidence. This may come simply with the passage of time. If the present situation prevails and nothing disastrous ensues then it will become ‘normal’ and playbook will be adjusted to the new norm. However, this will take an unspecified amount of time. Policy action which seems ineffective will delay normalisation as it will continue to disorient investors and cause anxiety. Doing nothing is now, psychologically, the optimal monetary policy response. Unfortunately, doing nothing is quite difficult for central bankers.

There is even a case for raising interest rates or, at the very least, ceasing and reversing quantitative easing. The logic is that it would puncture this profound sense of uncertainty by bringing the policy and market context back to familiar territory. It may have a negative effect short-term, though this is by no means a given, but it could quickly restore normal economic service. The alternative, it seems, is to remain stuck in this uncertainty paradox indefintely.

I confess my favourite polcy package at the moment is to cease QE, and introduce helicopter money combined with higher interest rates. The helicopter money would negate the initial impact of raisng interest rates and provided it was effected as a ‘one-off’ should have no long term consequences for expectations. Too imaginative for central bankers I suspect.