EN ROUTE TO NEGATIVE RATES
Alongside the usual suspects for the financial market volatility experienced since last summer (read: China, oil, dollar or US manufacturing), the anticipation of potentially adverse consequences from the latest central bank policy tool – negative interest rates – might have also played a role in disturbing investors. As the number of markets crossing the zero lower bound expands (Eurozone, Switzerland, Denmark, Sweden, Japan), it is worth reflecting on the costs and benefits of such a policy, as well as its potential implications for economies and investors.
Targeted benefits: lower real rates, currency and reserves
Cutting the key policy rate is the most direct tool at central banks’ disposal to fight deflationary pressures: reducing the cost of money theoretically pushes companies and households to borrow and invest. But when rates hit a binding zero lower bound and inflation continues to fall, the cost of money in real terms (real rates) actually rises, resulting in just the opposite effect. Allowing rates to move into negative territory, i.e. to fall in tandem with inflation, is a means to circumvent this problem. That said, in a world where demand is held down by ongoing deleveraging, it remains to be proven that negative rates can create inflation when they failed to do so at zero.
Negative rates also help to weaken the currency by reducing its relative attractiveness, in turn impacting inflation through higher import prices and improved competitiveness. However, if all central banks apply this same remedy, effects simply cancel out.
Finally, negative rates are also intended to discourage banks from hoarding excess reserves at the central bank (on which they are charged) and incite them rather to lend to the real economy. On this front, the Swiss and European experiences are not yet convincing.
Potential costs: weaker banks and less lending
To date, one effect of negative rates has been the flattening of yields curves, as the very need to resort to such a policy signals bleak growth prospects, exerting downward pressures on the long end of the curve, while the short-end has little room to fall. This penalizes banks’ profitability, since they “borrow short” and “lend long”. Worse, to the extent that banks do not impose negative rates on deposits, they continue to borrow at zero, meaning that effective yields curves are even flatter than they appear. In this context, banks can elect either to lend less (it not being profitable enough) or to increase lending rates (to restore margins), thereby tightening credit conditions for the real economy – and turning negative interest rates into a potentially deflationary policy! Moreover, investor confidence in banks could wane, leading to wider funding spreads and falling stock prices, initiating a vicious spiral for the banking sector.
Going forward, with Quantitative Easing (QE) programs now reaching their limit both politically – as in Switzerland, where the size of the central bank’s balance sheet is roughly equal to that of the economy – and in terms of their marginal effect – as in Japan, where QE expansion is no longer able to fight ingrained deflationary pressures – central banks may increasingly resort to negative interest rates as the new policy measure to weaken their currency and stimulate their economy (Chart 4). While we cannot totally dismiss some of the theoretical appeals of such action, it will definitely require major adjustments in how financial markets function, which could be destabilizing and force investors to review their investment approach.
First, moving too deeply into negative territory would hit banks’ profitability to an extent such that they would eventually find themselves forced to apply a “pass-through” and charge negative rates on their deposit base. Political and social resistance will then require some creativity to find a way to shield certain accounts, such as smaller depositors.
Second, central banks must think about how low they can go on rates without encouraging cash hoarding. How expensive is it to store physical cash relative to keeping it in a bank account? Should central banks cross this threshold, they might need to implement measures to limit large cash withdrawals, such as the ECB’s recent consideration of scrapping 500-euro notes or Larry Summer’s suggestion on his blog to reach a global agreement to stop issuing high-denomination notes. While these measures are intended to fight the use of cash for criminal purposes, they are – perhaps not so surprisingly – topical in the current context of expanding negative rates.
Third, central banks need to ensure that negative interest rates do not impair the smooth functioning of interbank markets.
Finally, as negative rates expand along the yield curve (Chart 5), implying a growing negative carry for bondholders, they could severely impact money market funds, which are also a source of funding for the real economy.
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