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Negative interest rates: The last bullet in the gun?

Piggy bank with two plasters

There is high volatility in the markets at the moment; stock markets are falling, oil prices remain very low, exchange rates are moving around a great deal and with big regional differences in GDP growth rates. In developed economies, interest rates overall are set at low levels; there is clamour to reduce global indebtedness whilst at the same time some countries are introducing negative interest rates to stimulate demand and GDP growth. This is feeding through to share prices. The overall impact is uncertainty for financial markets and the real economy.

This article will be useful to those in finance functions and related areas where the macroeconomic factors affect demand and performance of their business.

It will detail the linkages between the state of the economy, how and why we are seeing negative interest rates and the implications of this for national economies and individual businesses.

A brief recap

In the midst of the financial crisis, as the UK economy lurched into recession, the Bank of England took the unprecedented step of reducing interest rates from 5% in October ’08 to 0.5% in March ’09.

It soon became clear that this wasn’t enough and that it wasn’t so much the price of money that was the issue (i.e. the interest rate), but the quantity of money or credit available. In order to boost liquidity, the BofE introduced Quantitative Easing (QE), eventually amounting to £375 billion.

So is the economy back to normal?

GDP growth is ticking along, unemployment is low; inflation is low and stable and the balance of payment seems to be the only issue.

In the USA, the economy is powering along with solid GDP growth, low inflation and very low unemployment at 4.9%. Does anyone remember the phrase ‘jobless recovery’? It seems Obama will leave office later this year with a good track record on the economy capped by a budget deficit down from 12% of GDP to 2.5%. The US has recently raised interest rates and so the process of normalisation of monetary policy seems to have started. The Zero Bound (ZIRP) remained in place and off we go on the path of usual levels for interest rates.

While things are moving in the right direction, there is still real cause for concern about global growth slowing down, as reported on Reuters lately1.

At the same time, inflation is persistently low or negative leading to fears about deflation. The normal policy reaction to this would be to reduce interest rates… but with us being in ZIRP territory, how can we reduce rates? They can’t go below zero, can they?

It would appear they can. Japan has recently followed the EU and has put a negative base rate into effect.

Let’s think about that for a minute. If interest rates are – 1%, it means we’d be happy to deposit £100 at the bank today and receive £99 back in one years’ time. In other words, we’d be content to let the bank look after our money and pay them for the privilege of doing so.

While the negative rates set by the Bank of Japan and the European Central Bank are not as low as -1%, but are more like -0.1% and -0.3%, it would still be an huge sum of money given the volume of deposits held by commercial banks at the central bank.

So it’s fair to ask, what is the logic behind such a decision? By charging banks leaving funds on deposit at the Central Bank, it encourages them to use those funds rather then hold them, and using them means they would be trying to earn a return on those funds by lending them out. In other words, the Central Bank is trying to boost liquidity (again).

So, why the concern about even lower, negative rates? There are three strands to consider:

Negative rates are a bad policy option and may make things worse

  • The Bank for International Settlements feels the global economy is drowning in a sea of debt. According to an excellent McKinsey report from early 2015, global indebtedness increased post 2007 from 246% of GDP to 286% in 2014.
  • One of the possible effects of negative rates might be that it boosts aggregate demand via credit growth. So shouldn’t we be concerned about rising levels of indebtedness?
  • This school of thought thinks we are continuing the policy of ‘kicking the can down the road’, which has delayed the debt restructuring needed since 2007/8.

Apparently so, as the B of E has just announced it will monitor credit growth and take action if it grows faster than the economy2.

The banks’ profit margins are being squeezed as the spread between deposit and lending rates narrows. This puts downward pressure on already reduced bank valuations3.

Negative Rates are necessary to keep the global economy afloat

  • Banks remove deposits and use them to buy other assets; this increases asset prices and reduces yields, putting downward pressure on other interest rates
  • Banks use the deposits to increase lending, allowing aggregate demand to grow via increased consumption spending and investment spending by firms. In addition, firms and consumers respond to this as lower rates reduce the return s from savings, thus encouraging expenditure.

Additional aggregate demand from this growing liquidity and credit will maintain economic growth and stave off recession

Negative rates will be ineffective

  • Companies cannot be forced to carry out investment expenditure. Current surveys indicate the constraint on firms’ growth is actually down to a lack of profitable projects holding back capex, and not cost or availability of funds.
  • Consumers cannot be made to spend; consumption expenditure is driven by ability and willingness to spend. Lower rates may improve ability to spend, but willingness is driven by confidence.

With low inflation and negative rates, the opportunity cost of holding cash is very low. Some economists think consumers would hoard the extra cash rather than spend it, especially in an uncertain environment when confidence is lower4.

The consensus is that more liquidity is needed, as staving off global recession (with associated higher indebtedness) is the lesser of the two evils; the last bullet in the gun is that we implement negative rates and firms and consumers don’t play, and hoard the additional liquidity… and the policy armoury looks bare after that.

  1. http://www.reuters.com/article/us-imf-growth-idUSKCN0UX11Y
  2. http://www.telegraph.co.uk/finance/bank-of-england/12148080/Bank-of-England-poised-to-act-if-household-debt-spirals.html
  3. http://www.telegraph.co.uk/finance/economics/12149502/stock-markets-europe-banks-recession-crisis-crash.html
  4. http://www.ing.com/Newsroom/All-news/Negative-interest-rates-to-make-savers-hoard-.htm

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Roy Daintith, Senior Consultant of Macroeconomics, Leadership and Professional Development at Kaplan, believes that economics is fundamentally relevant to business performance and is passionate that decision makers should understand the bigger forces shaping and driving their industry.