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Fixed-Income Insights

A number of central banks have introduced below-zero interest rates to help boost growth and counter low inflation.

 

In Brief

  • Central banks in Japan, Switzerland, Denmark, Sweden, and the European Union have adopted a negative interest rate policy in the hopes of boosting economic growth and inflation. U.S. Federal Reserve officials say they have considered such a policy.
  • Negative interest rates may be an effective prescription for promoting economic growth and avoiding deflation, but such a policy must be carefully administered.
  • Why? Over time, broadly negative rates reverse economic incentives and change investor behavior, because they discourage saving and promote unnecessary borrowing.
  • The key takeaway—The concept that negative interest rates can promote economic activity and inflation seems rational, yet the long-term consequences of widespread negative rates appear economically toxic.

 

First of three parts.

Global central banks find themselves in unknown policy territory. The Bank of Japan (BoJ) recently surprised investors by introducing negative interest rates. This action was directed at a limited portion of bank reserves, but negative rates, consequently, spread to Japanese government debt with maturities of up to 10 years. Japan joins the central banks of Switzerland, Denmark, Sweden, and the European Union in adopting a negative interest rate policy (NIRP) in the hopes of boosting economic growth and inflation. 

Those policies, in combination with aggressive central bank securities purchases as part of quantitative easing programs, recently pushed the universe of outstanding negative-yielding bonds in Japan and Europe to $6.0 trillion, accounting for one quarter of JP Morgan’s index for government bonds, according to data from JP Morgan. Is the concept of negative interest rates sustainable? Is the United States next?

Negative interest rates—that is, when a lender gets back less than what was lent—seem not only anti-capitalist and counterintuitive but also, in theory, impossible. With cash available at a zero interest rate, who instead would choose to invest at a negative rate? Apparently there are some that will. And the lower interest rate is less than zero for many investors around the world. How negative a rate (that is, how far below zero) investors will tolerate has yet to be determined. The European Central Bank and the BoJ seem on track to test that limit in their efforts to stimulate growth and avoid deflation. 

Negative-land
Some level of negative rates may be tolerated by investors for the assurance of getting most of their money back, and, perhaps, for some level of convenience, especially if the situation appears temporary. However, sharply negative rates, or a long period of below-zero rates, demand consideration of cash as an alternative. At zero return, cash represents a more attractive economic alternative once the costs of storage, assuming something other than a mattress, have been overcome. Negative rates on government debt may soon be egregious enough to force investors to seek haven or yield elsewhere. Two-year notes in Switzerland and Germany, for example, recently yielded -0.95% and -0.51%, respectively, according to Bloomberg. Essentially, for every $100 invested in Swiss two-year notes, investors would receive back a little more than $98. 

Some investors may be required to hold government debt, but at some point, other investors may force a limit. Prolonged periods of substantive negative rates can give rise to serious economic problems. Over time, broadly negative rates reverse economic incentives and change investor behavior, because they discourage saving and promote unnecessary borrowing. Imagine, for example, a negative mortgage—that is, getting paid to borrow money to purchase a home. In such an environment, even timely mortgage payments to the bank would be discouraged, since the bank would have to reinvest in another negative-rate vehicle. 

Not only would the traditional banking business model be turned upside-down but also insurance companies would lose relevance. Their function of investing premiums and providing attractive death benefits or annuity income becomes a systematic asset-reduction plan as negative rates erode premiums and principal year after year. The same concept also would destroy the integrity of most retirement plans.

A New Wrinkle
Such an extrapolation of negative interest rates seems unrealistic. Yet, why would so many central banks pursue even small steps in the direction of negative rates, given the potential for such dramatic consequences? One interpretation may be that conventional forms of monetary policy have failed, and the use of negative rates may be a kind of economic Botox. Botalenium toxin, considered one of the deadliest substances in the world and researched for use as a biological weapon in the 1940s, can be beneficial in small, carefully applied amounts. Apart from its widely known cosmetic applications, Botox is used to treat a range of medical conditions such as migraines and muscle spasms. For central bankers who have run out of other policy options, negative interest rates may be one powerful (and potentially toxic) treatment for promoting economic growth and avoiding deflation, as long as the dosage is controlled and professionally administered. 

Here’s how it might work. By charging banks to hold excess reserves, central bankers hope to create incentive for banks to lend or otherwise invest those funds. At the same time, the aggressive purchase of outstanding government securities can push those rates into negative territory, encouraging investors to pursue higher-yielding, potentially riskier investments, thereby reducing those rates. The resultant increased lending by banks, combined with increased accessibility to attractive financing by other companies, should promote economic activity, jobs, spending and inflation. A resulting weaker currency also can promote exports. 

So far, however, the NIRP policies of Sweden, Switzerland, Denmark, and the European Union have yet to produce significant results. Economic growth is still a struggle. Lack of inflation remains a concern. And yet, perhaps those economies would be in worse shape without such policy; we don’t know. Clearly, the BoJ believes NIRP will help the Japanese economy. 

Can the U.S. Federal Reserve (Fed) be next as it considers the best ways to keep the U.S. economy from weakening? The idea has been discussed at the Fed. Chairwoman Janet Yellen, Vice Chairman Stanley Fischer, and New York Federal Reserve Bank president William Dudley each have suggested that negative rates could be considered if conditions warranted such a policy. However, having just raised rates in December, a move by the Fed to lower rates into negative territory seems unlikely and likely would send a hesitant signal to the already unsettled markets. 

Summing Up
The concept that negative interest rates can promote economic activity and inflation seems rational, yet the long-term consequences of widespread negative rates appear economically toxic. At some point, policymakers probably expect that negative rates can be reversed, and the economy will continue to improve on its own. Both central bankers and investors anxiously await proof of the effectiveness of a temporary dose of below-zero interest rates, with the implicit understanding that should negative rates spread throughout the economy, or persist for a considerable time, the health and stability of the financial system could be compromised. For central bankers, who have yet to identify a Plan B to contend with meager growth and low inflation, the response by global economies to this risky treatment will be crucial.

Next: What possibly could go wrong?

 

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