ZIRP, NIRP & QE – Central Bankers’ Panacea For The Main Street…

By: Ishwar Chidambaram, CFA

Functions of a central bank (CB) may include:

  • implementing monetary policies.
  • setting the official interest rate – used to manage both inflation and the country’s exchange rate – and ensuring that this rate takes effect via a variety of policy mechanisms
  • controlling the nation’s entire money supply
  • the Government’s banker and the bankers’ bank (“lender of last resort”)
  • managing the country’s foreign exchange and gold reserves and the Government’s stock register
  • regulating and supervising the banking industry

These days, the last named function supersedes the rest, with the increasing clamour for CBs to function as watchdogs of the financial markets. In the years before the financial crisis of 2008, the commonly accepted nostrum among the world’s central bankers was that financial markets were essentially self-regulating.  This belief was fuelled by esoteric theories like the Efficient Markets Hypothesis, which asserted that asset prices are inherently self-regulating and efficient and hence markets need no external regulation. Laissez faire was the order of the day. The global financial crisis of 2008 shattered these notions along with several other elegant financial theories. When Lehman Brothers collapsed, close to $15 Trillion of asset price values were annihilated overnight. This debacle led economists and thinkers to discredit the logic behind the “Laissez-faire” approach to central banking, which was the hallmark of the pre-crisis years. This soul searching led to a radical shift in the perception of Central Banks. They are now expected universally to act as watchdogs of the financial markets. In many countries, new legislation has been enacted vesting additional powers to the CBs. Thus CBs have effectively become “Rulers of Last Resort”.

  • ZIRP, QE, regulation, supervision and financial stability

As the financial crisis of 2008 roiled global markets, Central Banks worldwide embarked upon an alphabet soup of firefighting measures, most notably ZIRP (Zero Interest Rate Policy) and QE (Quantitative Easing). Some CBs have gone as far as implementing NIRP (Negative Interest Rate Policy). During the crisis, CBs became “Lenders of Last Resort”. The shockwaves from the collapse of Lehman Brothers cascaded through world financial markets, threatening the stability of the entire world economy. The global credit crisis led to an unprecedented cooperation and coordination between the major CBs- the Fed, ECB, BoJ, BoE and SNB slashed their key rates to near zero levels and held them low for long periods. This was the onset of the ZIRP regime. The key risk of ZIRP, namely inflationary pressures affecting price stability, is yet to materialize in the developed economies, where inflation is still quite low. ZIRP is now being replaced in many developed nations (eg- Switzerland, Eurozone, Sweden, Japan) by NIRP. Negative interest rates are spreading like a virus. It is speculated that when the next recession strikes, probably by 2017-end, the US Fed will follow suit and implement NIRP.

  • Preventing the next Global Crisis

The global crisis of 2007-08 was a watershed event in world history. It was caused by the vicious confluence of multiple factors, such as: Subprime lending, Housing Bubble, Easy Credit, Fraudulent Underwriting, Predatory Lending, Deregulation, Overleveraging, etc. In response, the US has enacted several proposals designed to pre-empt another similar crisis. The proposals address consumer protection, executive pay, bank financial cushions or capital requirements, expanded regulation of the shadow banking system and derivatives, and enhanced authority for the Federal Reserve to safely wind-down systemically important institutions (SIFIs), among others. European regulators introduced Basel III regulations for banks. It increased capital ratios, limits on leverage, narrow definition of capital (to exclude subordinated debt), limit counter-party risk, and new liquidity requirements. Today liquidity regulation is a key aspect of regulation, being a new tool in the financial stability toolkit. The Basel Committee on Banking proposed two indicators for calculating the liquidity levels at financial institutions as following: Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio. However, the jury is still out on whether these measures can prevent another global financial crisis. Critics contend that a lot more needs to be done to prevent another global financial crisis.

  • Regulation and Supervision: Separate Supervisory Authorities or Central Banks?

The latest trend is to concentrate monetary policy, regulation and supervision at one single institution (the central bank) despite the fact that previously there were two separate institutions.

Advantages of Central Bank Regulation and Supervision

  • CBs have all the information from the banking system.
  • Dual goal of price stability and financial stability is an achievable task

Disadvantages of CB Regulation

  • Would trigger a host of Moral Hazard issues, as supervision of banks would be controlled by bankers themselves; privatization of gains and socialization of losses
  • Financial systems have become too complex and risks are hard to predict and eliminate

Advantages of Separate Supervisory Authority

  • Would eliminate issues pertaining to Moral Hazard, as bureaucrats, not bankers, would be in charge of regulation.
  • Central Banks would be free to focus on single objective of price stability through more effective monetary policy

Drawbacks of Separate Supervisory Authority

  • Bureaucrats would be unable to comprehend the complexity and sophistication of risks in today’s advanced global financial markets
  • They would not have access to the level of information possessed by Central Banks on the banking and financial system.
  • ZIRP and QE: Impact of on the Real Economy and on the Financial Markets?

Adverse Effects of ZIRP, NIRP and QE:

  • Distort economic activity, when real rates are low or negative
  • Discourage savers, creating a disincentive for capital accumulation.
  • Incentivize borrowers to substitute debt for equity financing. This increases the leverage and consequently financial risk.
  • Lead to mispricing of risk, creating asset price bubbles and stoking higher inflation
  • Provide an artificial subsidy to Financial Institutions, enabling them to borrow cheaply and invest in higher yielding treasury securities
  • ZIRP and NIRP can create a liquidity trap, generated by low interest rates and high savings rates, which discourage domestic demand.

Beneficial Effects of ZIRP and QE

  • Lower credit costs, which boosts consumption and investment
  • Lower costs to refinance
  • Lower discount rates which increases NPV of future cash flows.
  • Companies and households consume more as they feel wealthier (Wealth Effect)


  • ZIRP and QE: Temporary Monetary Instruments or Instruments of the Future?

Someone once defined addiction as “When you can give up something any time, as long as it’s next Tuesday”. By this token, central banks worldwide appear to be addicted to ZIRP and QE. Einstein defined insanity as “doing the same thing over and over again and expecting different results”. Japan’s experience, involving 8-9 rounds of QE, clearly shows the limits of ZIRP and QE over a prolonged period of time. Yet CBs in developed economies view this as a panacea for current economic woes. CBs are deluding themselves that ZIRP and QE are only temporary, but this opens a Pandora’s box which cannot be closed. CBs are fast approaching a point of no return, akin to keeping a patient (the ailing world economy) on life support even when the patient shows no signs of responding. Instead, monetary policy instruments of the future should include policies for improved transparency, better risk management, and enhanced credit, collateral and liquidity management.

  • ZIRP and QE: Inflationary pressures in the economy?

ZIRP and QE, when implemented over extended periods of time, can produce a number of distortions. In particular, the adverse effects include asset price bubbles due to mispricing of risk, which lead to boom and bust scenarios. Investors tend to drive up demand for non-income bearing assets, like alternative investments and commodities, in the hope of price increases. QE increases the supply of money, increasing the disposable cash in the hands of market participants. More money chases fewer goods, driving up asset prices in general, triggering inflation. This is evident from the stock market levels of most developed economies, which are at all-time highs, indicating a potential asset price bubble. Such distortions can persist for years or even decades, creating the impression that asset prices are fairly valued. The case of interwar Germany (in the 1920s) forms a textbook case. The Weimar Republic resorted to large scale currency printing (QE) to meet Germany’s war reparations. This triggered runaway hyperinflation, which hit 3,250,000% in 1923 (prices double every two days).

  • ZIRP and QE: Impact on Developed and Emerging Markets

Developed Markets

  • Impact has been relatively benign, as evident from the case of USA and Japan, where a combination of ZIRP and QE was used to recover from recession
  • No evidence of runaway inflation till date as weak demand and high risk aversion kept inflation rates very low

Emerging Markets

  • Several emerging markets have witnessed a sustained bull run, due to increased inflows of foreign capital (dollars) chasing higher yield
  • This is especially true for EMs with current account surpluses, which have seen their currencies and asset prices appreciate
  • Nations with current account deficits have generally seen their currencies depreciate due to foreign capital outflows (exception- the Indian rupee, which has been one of the best performing currencies in 2016)


  • Crisis Dynamics: Possibility of new Financial Crisis
  • The current recovery has been rather tepid and has run its course in the developed markets
  • Although equity markets are at all-time highs, the sentiment on the Main Street is not euphoric. The labour market is still experiencing some pain, as indicated by US non-farm payroll data, which came in below expectations.
  • If the Fed hikes rates in September, the equity markets will sell off in a knee-jerk reaction. There is low probability of a rate hike in September, given the dovish Fed.
  • A new recession is around the corner, and will occur, probably by calendar year-end of 2017, possibly triggered by events in Europe and/or China
  • Confronted with the prospect of another recession, USA will follow other countries and implement Negative Interest Rate Policy (NIRP). This was implicit from the Fed’s deliberations at Jackson Hole.
  • Situation of negative rates will be bearish for the US Dollar and bullish for commodities like Oil, Gold, etc. which are priced in dollars.
  • A hard landing in China, due to collapse of shadow banking system and/or implosion of toxic wealth management system will make the next recession even more difficult for emerging markets



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