Kicking ZIRP could be accompanied by pain in the form of recession or a break in the financial system.
For many years, we’ve written about our belief that the global economy is akin to a living organism that progressively adapts to its changing environment. In that regard, Darwin’s theories are as important as college textbooks and doctoral theses in the pantheon of economic thought. Sadly, the moving target presented by an evolving economy also makes forecasting its future a bit of a fool’s errand. Traditional static models and historical data have a decay factor, meaning they become less useful as time passes. That sets the stage for economic surprises and crises that seemingly appear out of nowhere.
Since the 2008 financial crisis, the global economy was mutated by central banks seeking to create growth and lift inflation rates to higher but still benign levels. For more than a decade, the U.S. Federal Reserve was on the front lines of an effort to achieve a 2% average inflation rate that it considered supportive of acceptable rates of growth. Zero interest rate policy, or ZIRP, was adopted to remedy an economic hangover from the crisis, so the central bank’s balance sheet was exploded in size to create looser financial conditions. Along the way, the financial ecosystem adapted to its new ZIRP environment to the point where any change in direction would be disruptive.
There is little question that recent high inflation is a byproduct of imbalances created during and in the aftermath of the COVID-19 pandemic. It turns out printing a mountain of new money while nearly shutting down production in the economy is inflationary. Who knew? (Yes, that’s sarcasm.) Inflation wears at the very fabric of a nation far more than a typical recession, so policymakers have staunchly committed to stopping it in its tracks. They’re using all the tools they have at their disposal, and that has led to an abrupt reversal of ZIRP.
Financial markets and the economy are now experiencing disruption similar to what a long-term smoker experiences when he quits cold turkey. Breaking the ZIRP addiction that formed as the economy adapted to its post-crisis environment won’t come without pain, likely in the form of a recession. It also increases the probability that something in the financial system will break. It’s an economic version of a nicotine fit, and it’s more than a theoretical concern.
We’ve recently watched liquidity problems emerge in systemically important markets. Specifically, the U.S. Treasury market is starting to wobble like it did in the early days of the pandemic. The stakes are high because liquidity in the world’s bellwether bond market is a critical enabler of a sound financial system. Disfunction there can lead to problems everywhere. UK gilts provided a small example of how trouble in government bond markets can emerge with lightning-fast speed. For a few days in October, the UK financial system was dropped to its knees as gilt yields spiked higher. Disrupted currency markets are also sounding the alarm.
We should emphasize that financial crises in the U.S. are tail risks with low probabilities in all environments. Even so, current high inflation rates tie the hands of policymakers who normally ride the rescue when one occurs. Whatever happens, breaking the global economy’s addiction to ZIRP will not be easy, and investors should set expectations accordingly.
Scott D. Knapp is chief market strategist with CUESolutions provider Cuna Mutual Group, Madison, Wisconsin. He is responsible for investment philosophy development and program implementation for Cuna Mutual Group’s institutional retirement programs. He regularly speaks at economic and investment forums across the country. Connect with him on LinkedIn.
The views presented here are the author’s alone and not necessarily representative of opinions held by CUNA Brokerage Services, Inc. or any affiliated entity.
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