Recent monetary policy developments may offer a welcome uplift for insurers.
By Joseph Becker, Portfolio Strategist, Milliman.
Structurally low—even negative—interest rates and bond-purchase programs have been mainstays of monetary policy in the decade-long era following the global financial crisis. It’s a climate that has worked to the detriment of insurers seeking long-term, low-risk investments.
Central bank bosses have to get some credit for their creativity since 2008. But eight years of rock-bottom interest rates and quantitative easing (QE) have left central banks with almost nowhere to go. At the end of November the Organisation for Economic Co-operation and Development (OECD) spelled this out with admirable clarity: “Monetary policy has reached its effective limits in many advanced economies,” it said.
The summer 2016 cut in UK interest rates from 0.5% to 0.25%, the strong indication from the European Central Bank (ECB) that rates will remain at or below zero, and the inaction of the Bank of Japan, all suggest that the monetary policy armory is pretty much spent. Only the U.S. Federal Reserve is left hoping it has scope to get out of the ‘lower for longer’ scenario. This now seems increasingly likely following the election of Donald Trump. His promised fiscal stimulus—through infrastructure investment and tax cuts—will generate upward pressure on inflation, giving the Fed greater latitude to make additional rate increases.
Elsewhere, amid signs that monetary policy strategies are failing to revive economies, other ideas—including “helicopter money”—are being discussed, as central banks strive to remain at the heart of economic policy.
The term helicopter money was first used by American economist Milton Friedman in the late 1960s. His idea was to raise inflation and output in an economy running substantially below potential by facilitating direct money transfers to consumers. As an extreme option, Friedman envisaged a helicopter dropping cash from the sky.
In 2002, former U.S. Federal Reserve chairman Ben Bernanke revived interest in the concept, extending it to embrace broad-based tax cuts as a way of quickly increasing consumers’ spending power. He also introduced the idea of central banks buying substantial amounts of debt at the same time, to keep a lid on interest rates. QE has been a limited version of the latter without the former.
Bank of England (BoE) governor Mark Carney did manage to find something new in the form of a GBP 100 billion term-funding scheme for banks. This could have a genuine impact on banks’ willingness to lend to businesses, though it has to be matched by businesses’ desire to borrow. It is an attempt to address the failure of QE to have any discernible impact on the real economy. It is also being seen as a subtle shift in policy toward a form of helicopter money, though this is something the BoE vigorously denies.
Central banks are cautious about the concept of helicopter money because it is, essentially, a fiscal policy tool—in itself an acknowledgement that existing policy is no longer having the desired impact. Though economists and politicians are starting to mutter about the lack of room for monetary policy maneuvers by central banks, the banks themselves are reluctant to admit publicly to any such fears. But fiscal policy is now coming into much sharper focus, especially in the United States.
The simplest fiscal stimulus option is a government cash handout to its citizens to boost consumer spending. But in modern, sophisticated economies, this is more likely to be done through substantial tax changes. Indeed, this has already been done to an extent in Australia in 2009, and in the U.S. Economic Stimulus Act in 2008. Perhaps the fact that these two economies are in a better place post-crisis than others suggests the policy does have some impact.
Publicly financed infrastructure
Another option could be large-scale publicly financed infrastructure programs, straight out of the Keynesian handbook of responses to economic depression—and another likely feature of the new U.S. policies.
If these policies contribute to higher economic growth, insurers would be likely to benefit. The infrastructure approach, however, offers the potential to benefit them in more ways than one.
Infrastructure investment could be a part-public, part-private finance initiative, with the private finance element provided through infrastructure bonds. They would be a welcome addition to the asset options for insurers needing to match long-term liabilities, and would be a much sought-after asset class. Whether the ECB and European governments show the same enthusiasm as President Trump for renewed public investment remains to be seen.
For insurers, the exceptionally low rate environment of the past several years has posed a formidable challenge. As long-term, higher-coupon bonds have matured, it has been virtually impossible to reinvest the proceeds at the same yields without taking on substantially more risk. To add injury to insult, falling rates have simultaneously increased the value of insurers’ liabilities.
Looking ahead, to the extent that fiscal policy can take the reins from a fatigued monetary policy in stimulating economic growth, it may give the Fed breathing room to continue raising short-term rates. Likewise, as economic growth contributes to consumer and investor confidence, longer-term rates may also continue to climb, offering a bit more room to breathe for insurers as well.