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Negative interest rates

04 May 2016

Some central banks are treading a tightrope by cutting interest rates in a bid to encourage the banks to lend.

On 10 March 2016, Mario Draghi, President of the European Central Bank (ECB), announced the latest set of measures designed to stimulate the eurozone and steer it away from what central bankers regard as the dangerous waters of deflation.

As a central banker who is closely associated with ‘big bazooka’ monetary measures, Draghi used plenty of ammunition. The ECB increased its monthly asset purchases – also known as quantitative easing – from €60 billion to €80 billion, and announced a scheme to give Europe’s banks new incentives to lend. It also took its deposit rate further into negative territory, reducing it from -0.3% to -0.4%1.

Historically, the setting of a negative interest rate by one of the world’s major central banks would have seemed so odd that it would have sent shockwaves through the financial markets and the wider economy. For the ECB, however, it is almost old hat. It first reduced its deposit rate below zero in June 2014 and the latest move is just another in the sequence.

And the ECB is not alone. In January, the Bank of Japan also adopted negative interest rates, just months after its Governor, Haruhiko Kuroda, had suggested there was no need for it to do so. The Swiss National Bank also has negative interest rates, as do the central banks of Sweden and Denmark.

Why is this happening? For central banks, the interest rates they set are typically on the reserves that commercial banks hold with them, so in that sense the banks are a captive audience. As Paul Sheard, Chief Global Economist at ratings agency Standard & Poor’s, puts it: ‘Central banks can do this because they get to determine the total amount of liabilities they issue, giving them the unique ability to set both the quantity and the price.’

That explains how central banks can break the normal rules and set negative interest rates. But why do they do it? The fall in inflation, which has been brought about by weak oil and commodity prices, has worried central bankers, who do not want deflation to become embedded. It has also meant that, while a zero interest rate looked very low when inflation was, say, 2%, it no longer looks so low when inflation itself is also zero, or when prices are falling. In other words, to provide the same stimulus, official interest rates have to go negative.

Central banks are also keen to ensure that commercial banks have an incentive to lend to businesses and households. Some of the reserves held at central banks are there for regulatory reasons, but some are there because the banks are choosing that course of action, rather than using them more productively; they are ‘excess’ reserves. A negative interest rate on these reserves – in effect charging commercial banks for keeping their money at the central bank – should either encourage them to move it into other assets or increase their lending into the real economy. In theory, it should no longer be sitting idle at the central bank.

The other powerful consideration for central banks has been the exchange rate. Readers with long memories may recall that Switzerland adopted negative interest rates on foreign deposits in the 1970s. The aim then was clear: ‘hot’ money flows – partly as a result of the sudden riches enjoyed by oil-producing countries – had a destabilising influence. Their effect on safe-haven currencies such as the Swiss franc was to push them sharply higher. Switzerland’s course of action was intended to stop that happening, or at least limit it. Preventing currencies from rising – and in some cases securing a competitive devaluation – has been part of the motivation for the negative rates set by the ECB and the central banks of Switzerland and Japan. Clearly, not everyone could achieve a lower value for their currency if all were to adopt negative rates, but those who act quickly can steal a march on others.

Are negative rates here to stay? If so, how much further can they fall? While the experiment has yet to play out, there is a limit to how much longer rates can drop or remain in negative territory. Before his move in March, the ECB’s Draghi was warned by the banks that his policy was hurting them, and that any further reduction in the rate would do damage.

After announcing another small cut he offered broad hints that the process would not go much further.

At the ECB’s conference following the rate cut in March, Draghi said: ‘How low can we go? Rates will stay low, very low, for a long period of time. Let me also add that the experience we’ve had with negative rates, in our case at least, has been very positive in easing financing conditions, and in the transmission of these better financing conditions to the real economy.’

There is, in addition, serious resistance to setting negative interest rates at other central banks. The Federal Reserve in America embarked on a process of raising rates late in 2015, while Bank of England Governor Mark Carney warned in a speech in February that using negative interest rates to achieve a lower currency was ‘a zero sum game’. The risk, he said, was of creating what he described as ‘a global liquidity trap’, in which the actions of central banks lose any force. There was, he said, ‘no free lunch’ for central banks in negative rates. Only time will tell whether circumstances will force him to change his view.

Up to now, negative interest rates have operated in the rarefied zone of central banks, and in their dealings with commercial banks and the money markets. But how would ordinary savers respond to negative rates; to their money being worth less in a year’s time than it is now? It is not as far-fetched as it sounds. In recent years, savers have been happy to keep their money in the bank – earning a return barely above zero – even when inflation has been much higher. Negative real interest rates have been the post-crisis norm. People are also happy to pay a monthly fee – ostensibly for bundled products – on current accounts, which in many cases equates to a negative interest rate.

Both are, however, different psychologically to an explicit negative rate; a savings regime that would see the value of your money, in purely cash terms, decline year after year. How would people react? We can guess, or we can draw on research carried out recently by ING, the Dutch-based international bank. ING surveyed 13,000 people, mainly in Europe but also in the US and Australia.

The results suggest that if policymakers think that individuals would respond to negative interest rates by spending more and thereby boosting the economy, they are probably wrong. Further, negative rates would be very bad for the banks.

As Mark Cliffe, ING’s Chief Economist, puts it: ‘A remarkable 77% said that they would take money out of their savings accounts. While a few would spend more, this would be offset by almost as many saving more. Most said that they would either switch into riskier investments or hoard cash “in a safe place”. This is better news for safe-makers than it is for banks and central banks.’

The most surprising aspect of ING’s findings was not that negative interest rates would be of limited value in boosting spending. After all, savers still need to put money away for a rainy day, a house deposit or some other future need. It was that so many would regard it as a reason to desert their banks. So for the banks, an experiment with negative rates for ordinary customers could prove to be very difficult, if not disastrous.

‘The banks would be faced with an uncomfortable choice between not cutting retail rates below zero, and so seeing their profit margins squeezed, or doing so and risking a substantial deposit outflow,’ says Cliffe.

Negative interest rates are in fashion among central banks. However, even among them, there is some disquiet. There would be even more disquiet if ordinary savers were expected to pay banks for the privilege of keeping their money safe. Fortunately, that is unlikely to happen.

1 www.ecb.europa.eu, 2016

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