Negative Interest Rates: Not Coming To Your Bank SoonPosted: May 17, 2015
Negative interest are yet another paradox in economics. Mainstream theory suggests that a rate of interest below zero should be impossible. Rational actors would never accept negative rates, choosing to hold on to cash instead and withdraw it from the financial system. However exercises in Denmark in 2012 and the ECB and Switzerland in 2014 have shown not only that negative interest rates are practically possible, but that they are gaining some acceptance in the central banking community as a legitimate tool. Furthermore, with developed economies trapped near the zero nominal lower bound and therefore needing additional stimulative tactics, their wider use seems increasingly more attractive. However the fact that negative rates have not been widely implemented in a world where extraordinary policies like Quantitative Easing has become common place, in spite of their obviousness, suggests that there are crucial reasons why policy makers have been so reluctant to use the tool. Reasons that will prevent mainstream implementation in the future.
This piece will discuss the premise of negative interest rates, their potential as a stimulative tool and their systemic impact to economies.
Desperate times call for desperate measures?
When economies are in need of stimulus, central banks will reduce short-term interest rates in an attempt to increase liquidity in the economy and therefore prompt growth. As the situation becomes more desperate, the interest rate figure moves closer and closer to zero – “the zero nominal lower bound” – and the stimulative impact of further marginal reductions in rates becomes weaker. This situation has been described as “the liquidity trap” – and was well observed during Japan’s 20 years of stagnation since the 1990s and in developed economies in the shadow of the Global Financial Crisis (GFC).
Traditionally, rates have not moved into negative territory because of arguments that it would confuse economic actors by skewing transmission mechanisms and parties would negate the impact by funnelling money elsewhere – especially into cash. However it has been practically shown that some central banks have pushed core rates into negative territory as part of in the desperate period post the GFC. Thus in the next section we shall discuss how central banks may utilise negative interest rates.
The textbook method and likely weaknesses
Central banks have a range of interest rates they may manipulate. Thus there are a great number of tactical combinations that a central bank may use. However the simplest chain of implementation would be as follows. First the central bank lowers the bank rate – the interest rate commercial banks’ reserves are charged by the central bank – into negative territory. In reaction, the desirability for commercial banks to keep their reserves with the central bank diminishes. They will then put the money to use in the economy in search of a positive return and thus re-stimulate growth in the economy. Furthermore, there would be downward pressure on the rates of loans already in the economy, increasing available liquidity for all other actors: e.g. mortgagors.
Naturally, this chain of events may not have the certainty suggested. During times of great economic distress, as may have prompted the need for negative interest rates in the first place, domestic investment opportunities for commercial banks may not exist or may be hidden by ongoing volatility. Thus the money will be spirited off internationally and therefore the exercise will have a reduced positive impact on the economy. And the situation will have weakened the resilience of the domestic banking sector because financial reserves are not in place for systemic protection. Alternatively, commercial banks actively use a wide range of interest rates to define their commercial decisions, so the fact that a single rate (or a few) has moved into negative territory has only impacted a small slice of their portfolio. As such, the stimulative impact may be underwhelming.
The factor that defines the potential success of the policy is the extent actors believe the central bank will keep rates negative for an extended period of time. If actors believe that the central bank will keep rates negative for a long period of time, it will shape commercial banks behaviour more solidly and increase the likelihood of positive stimulative impact. However, if the negative rates do get passed on to current accounts and other deposits, actors are less likely to use banking services and just keep their cash in sock drawers, under mattresses or internationally. In the traditional analysis of financial systems – this would chronically corrupt the source of loanable funds in the economy and threaten a worse economic state. Thus a paradox, you would need to keep negative rates for as long as possible however the longer they are maintained the greater the potential corruption of the economic system you are trying to aid. Where central banks have attempted to utilise negative rates therefore, they have had to be highly selective in scope – utilising any the signalling impact of actual negative rates to encourage direction. The Danish example best illustrates this schema. In 2012 the Danish Central Bank used negative rates on “excess” reserves held at the bank only: the attempt to limit the opportunity for financial sector systemic issues. Problematically, not all central banks have such an opportunity because they do not have such interest rates to control. In fact if central banks have been following the recommendation of orthodox economics under the New Consensus, they would have purposefully designed their systems with fewer such reference rates and would not be able to intervene so selectively.
Although the Danish example does raise an alternative route for stimulative success. The negative rate signalled to commercial banks and actors that wider introduction may occur, driving funds abroad as previously discussed. This actual encouraged a depreciation in the Krone as the funds flooded out, subsequently opening an exchange rate advantage for Danish goods and an alternative opportunity for growth. However again, this route is reliant on a solid belief that the negative rates will be in place for the long term, otherwise the depreciation will be temporary and will have merely encouraged further economic volatility.
Being characteristically cautious, central banks have been highly reticent to use negative interest rates as a stimulative tool. Going to the logical conclusion of the policy, their use are likely to have long run impact on the way actors behave in the economy and hence risk capitalist mechanisms. This suggests that, as has been witnessed practically in the post-GFC global economy, their value mainly lies in their shock value and not innately. Arguably, alternative routes such as forward guidance may achieve the same objective without the long term risk. Thus the rise of widespread negative interest rates to core rates under central bank remits is unlikely and alternative stimulative methodology will remain preferable.
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