Both Wall Street and the City of London are speculating whether the next innovation in monetary policy will be the use of negative interest rates as a deliberate tool. The new Governor of the Bank of England, Andrew Bailey, has changed the Bank’s position from that of the previous Governor, Mark Carney, who made clear that negative interest rates were not a proposition he was seriously considering. The central bank’s Chief Economist, Andrew Haldane, and one member of the Monetary Policy Committee (MPC), Silvana Tenreyro, have canvassed the idea.
In the US, President Trump regards the merits of negative interest rates as a no-brainer, as he has made clear on Twitter. The Federal Reserve Board, in contrast, is much more cautious and reticent. The Chair, Jay Powell, has made it plain that the Fed is not considering negative rates. His position has been buttressed in a series of speeches and interviews by a Praetorian guard of regional federal reserve bank presidents, who have expressed reservation about the proposition.
Markets test negative interest rates in the Anglosphere
The changed mood has been reflected in financial market speculation, resulting in negative yields. Futures traders have tested a negative Fed Funds rate in New York and in London, as the Debt Management Office has sold three-year gilts at yield of minus 0.003 per cent. This negative yield means that investors will receive less than they paid for the bonds when they mature in three years’ time. In 2016, the UK sold a one-month Treasury bill at a negative yield, but this is the first time a conventional gilt was sold with a yield below zero. The result of the auction shows the strong demand for UK Government bonds – the auction was covered by 2.15 times the amount being raised, with £8.1 billion of bids. Financial market practitioners are alive to a potential further instalment of unconventional monetary policy.
Theoretically, negative rates are the next logical innovation in unconventional monetary policy
Negative interest rates have been used in the past in continental Europe and Japan. In some instances, their purpose has been to raise inflation to the central bank’s target – indeed, this was the reason why the ECB turned to negative rates in 2014. There is, however, a big difference between markets accepting negative yields at an auction, and a central banking choosing to use negative interest rates for its official interest rate benchmark or repo.
Theoretically, for monetary policymakers seeking to make policy relevant in a liquidity trap, negative interest rates are the counter intuitive yet logical device to escape the zero boundary that sets a floor to interest rates. However, when monetary policy has lost the capacity to stimulate, and innovations such an quantitive easing, bond buying programmes, credit guidance and forward guidance have failed to give it effective traction, it is not clear that negative interest rates will yield the results that policymakers seek.
Negative interest rates should, in theory, stimulate economic activity by giving banks an incentive to lend or invest excess funds to avoid having to pay penalties on funds in bank accounts. Yet the effects of the negative interest rate policies introduced between 2012 and 2015 in European economies are difficult to assess. True, further extensions to the Great Recession were avoided, but economic growth has been anaemic and weak banking profitability has constrained credit growth and given financial institutions further incentives to seek greater risk.
Undermining the profitability of the banking system and blunting monetary transmission
Under negative interest rates, banks would have had to absorb the charges that arise from having to deposit their own money with the central bank every day, whereas in normal market conditions with positive interest rates they would be earning interest. So in a way, they pay the central bank an equivalent of a tax. According to the well-known definition, banks make money on the spread between what they have to pay customers in interest to attract their cash deposits and the interest rate they can charge for lending that money out to borrowers. In recent years, to minimise the damage to their fundamental profitability, retail banks have been unwilling to cut their lending rates to customers beyond a certain level, weakening the pass-through of official rate policy and the monetary and credit transmission mechanism.
The Swedish Riksbank was the first central bank to consider formally the use of negative interest rates as a policy instrument and introduced them in 2015 to prevent deflation. By contrast, the Swiss National Bank and the Japanese central bank have used negative interest rates as a device to lower the exchange rate. The results have been mixed. The ECB and the Swiss National Bank consider them to have been successful in supporting bank lending and economic activity. But the impact on savers, banking profits and the funding of pension funds has been problematic.
Sweden’s monetary experiment
The Swedish Riksbank is the world’s oldest central bank, founded in 1668. It has more influence on the thinking of the international central banking community than may be appreciated. It was one of the first monetary authorities to embrace inflation targeting, while its Governor, Stefan Ingves, chaired the Basel Committee on Banking Supervision between 2011 and 2019.
The Riksbank engaged in a large-scale monetary experiment when it announced a negative repo rate in 2015. However, it decided to abandon it and to returned the repo rate to zero at the end of 2019, having previously expressed satisfaction with the policy initiative for bringing inflation close to its target. Yet it was plain from complaints from Swedish banks and insurance companies that it generated awkward results for the financial system. They made it clear last year that they wanted the policy to be undone even if an interest rate increase were to hurt the economy.
Swiss experience illustrates the limitations of monetary policy in the context of structural change
The Swiss National Bank and the Bank of Japan turned to negative interest rates principally as a tool of exchange rate management. They did not want their currencies to rise against the euro and the dollar. For the Swiss central bank, it has not been a policy instrument without problems. It found it was not possible to limit its impact to the wholesale market, with banks exploring the possibility of applying negative rates to large retail deposits, and it has impaired the financial transmission mechanism. A fundamental problem with the Swiss policy has been that the central bank has used a monetary tool to resist the structural consequences of increasing Swiss competitiveness on the exchange rate. This can only be done for a limited period without monetary distortion.
The Reversal Rate and short-term benefits
Negative rates appear to offer a short-term stimulus that progressively fades. This is the judgement of market practitioners. It offers a form of a sugar high. Academic economists at Princeton, Markus K. Brunnermeier and Yann Koby, in a paper The Reversal Interest Rate, identify a point where low interest rates create more harm than good due to market distortions. They imply that the rate may not be at the zero-rate boundary, but at some point, negative interest rates will no longer be a source of reliable stimulus in the context of an extended liquidity trap. ‘Over time the reversal interest rate creeps up since asset revaluation fades out as fixed-income holdings mature while net interest income stays low.’
Financial disintermediation and aggravating financial market risks
Negative rates create incentives for risk and financial disintermediation, as shown by Denmark, the first country to set negative rates in 2012. The Danish banking regulator has warned that persistent negative interest rates could drive banks to market riskier savings products to their customers, after it was forced to report Danske Bank to the police given the risk of some of its financial products.
The ECB negative interest rate policy introduced to stabilise its rate of inflation has had mixed results as a source of stimulus, and resulted in awkward and unwelcome monetary consequences. It has encouraged effective disintermediation from the banking system that has destabilised a bank’s revenue generation. Savers threatened with negative interest rates and already enduring very low interest rates seek higher returns from other financial products provided by non-banks and asset managers.
In Switzerland and Germany, commercial banks attempted to push the burden of negative interest rates onto their customers. They started with big institutional clients and tried to move on to ordinary businesses and individuals. Banks were thwarted in this by depositors that had other options, including withdrawing their funds in cash. Dutch pension funds have expressed serious concern about the funding and liquidity implications that have arisen from negative bond yields.
Conclusion
Negative interest rates are along with the other unconventional monetary innovations since 2008 an attempt to get a policy that cannot properly function in the context of a liquidity trap to work. It would be better for policy makers to concentrate on employing the other arm of macro-economic stabilisation, fiscal policy, along with a suitably accommodating monetary policy. It will probably be better to avoid artificially constructed official negative interest rates. If they emerge in bond markets as part of a market response to active fiscal and monetary policy they should not be resisted, but policy makers should not be deliberately setting negative rates. This was the gravamen of IMF advice to Japan this week: concentrate on getting fiscal policy right and take negative interest rates no further.
They have the potential to provoke the cash hoarding and precautionary saving that the policy is intended to counter. Taxes and initiatives such as negative rates that are intended to force economic agents into doing things that they are reluctant to do often have a recondite appeal in the academic seminar room, but disappoint in a practical environment. Moreover, things are not helped when, as Stefan Ingves commented on Swedish negative interest rates, “the public find the whole policy strange”.