Vol 8 (2011) - Issue 5

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Financial Repression and Search for Yield

'We have entered a protracted period of exceptionally low interest rates. We call it "financial repression".'

The Fed’s downbeat assessment of the economy and recent policy events have led the central bank to undertake the unprecedented move of committing to very low interest rates at least through mid-2013 and to use additional policy tools (i.e., QE3) if needs be.

Such a policy stance serves two purposes: a) It buffers the negative effects of fi scal austerity and macro event shocks; and b) it reduces the government’s interest expenses on the debt and contributes to defi cit reduction. In a recent article, Carmen Reinhart revisits the concept of ‘fi nancial repression’, namely that of keeping interest rates lower than they would be in competitive markets.1 She adds that when fi nancial repression produces negative real interest rates, it reduces or even liquidates debt. This is the equivalent of a tax on wealth, a transfer from savers to borrowers.

In other words, the course of normalization of interest rates, during which the yield curve steepens in anticipation of growth resumption and central bank tightening, has been interrupted at least until mid-2013. Instead, short-term rates are anchored by the near-zero central bank rate, while longer-term yields stay low or move even lower, as investors seek yield (Exhibit 1). The fl attening of the yield curve would be enhanced even further in the event the Fed embarks on one of its QE options, namely the lengthening of maturity of its holdings.

Three shocks drastically changed market sentiment that saw the Q2 soft patch as temporary:

– The very poor handling of the recent debt ceiling negotiations and lack of leadership in policy making;

– The worsening of Europe’s debt crisis and its contagion effect;

– The ill-timed S&P downgrade.