Who’s afraid of negative interest rates?

During the crisis in 2008-09, major central banks such as the US Federal Reserve and the Bank of England found that reduction of interest rates to almost zero failed to stimulate the economy. One instrument they experimented with was quantitative easing (QE). With this new instrument of monetary policy, central banks created money by buying securities such as government bonds with electronic cash. As the new money increased the size of the banks’ reserves through the quantity of assets purchased, the phenomenon was called QE.

In the same way as lowering interest rates, QE is expected to stimulate the economy by encouraging banks to lend more. When banks buy new assets with the new money they have received to replace the bonds they have sold to the central bank, stock prices go up and interest rates go down. This in turn boosts the economy and increases investor confidence. QE has been responsible for raising the value of assets of the US Federal Reserve from less than $1 trillion in 2007 to $4 trillion in November 2015. The move of the European Central Bank (ECB) and Bank of Japan (BoJ) to bring official interest rates below zero should be perceived as a continuation of QE.

Hardly a parlour game Ten years ago, negative interest rates were a theoretical curiosity that economists would discuss almost as a parlour game. Two years ago, negative interest rates started as an unconventional step that only a few countries considered. Today, it has become the policy of some of the most powerful central banks such as ECB and BoJ. In June 2014, the ECB started paying minus 0.1 per cent on deposits and lowered it further to minus 0.2 per cent in September 2014. While Denmark and Switzerland already had negative interest rates, on February 12, 2015, Sweden joined the fray.

According to central banks, making interest rates negative will boost their economies. A few days ago, Sweden’s central bank lowered its bank lending rate to a negative 0.5 per cent from a negative 0.35 per cent and said it could be cut further. European bank stocks took a beating partly because investors feared negative interest rates would affect bank profits.

The US Fed Reserve chief Janet Yellen acknowledged in a congressional testimony last week that she was open to the possibility of introducing negative interest rates. According to the Canada-based Centre for Research on Globalization, more than one-fifth of the world’s GDP is in countries that have imposed negative interest rates. That includes Japan, the EU, Denmark, Switzerland and Sweden.

Unknown quantities As the economic journalist Neil Irwin notes, “As negative interest rates — in which depositors pay to hold money in bank accounts— become a more common fixture there are many unknowns about what these policies mean for finance, the economy and even for the definition of money.” According to CNBC, the Bank of Canada is most likely to opt for negative interest rates either this year or next year. Norway already has a negative reserve rate of minus 0.25 per cent which is the rate paid on deposits at Norges Bank that are in excess of the quota for sight deposits. The country may also opt for negative interest rate when it announces its next rate decision on March 17.

Israel has been dealing with deflation since 2014 and consumer prices fell by 0.1 per cent a month prior to December 2015.

While Israel will update its decision on February 22, the Citigroup’s economists led by Ebrahim Rahbari predict that the Czech Republic, Norway and Canada are most likely to introduce negative interest rates within the next one or two years.

According to the UK-based Oxford Economics, markets are predicting a greater than 0.50 per cent rate cut in the UK in 2016. This development should be seen against the backdrop of the UK being perceived as the next to hike interest rates after the Fed.

The Bank of England has held its main bank rate at 0.5 per cent since March 2009 and is expected to announce its decision on March 17. According to UBS economist David Tinsley, since the UK economy is smaller and more open than the US economy, it might benefit more from the weakening impact of negative interest rates on the exchange rate. According to Citi, the Czech Republic may introduce negative deposit and repo rates of around minus 0.1 per cent between April and June this year. Though the Czech Republic is not a part of the Euro Zone, two of its major trading partners, Germany and Slovakia, are, and a further rate cut by the ECB could influence the decision on negative interest rates when the Czech national bank announces its policy decision on March 31.

A new era Authors Jana Randow and Simon Kennedy held that negative interest rate is an “unorthodox choice that has distorted financial markets and triggered warnings that the strategy could backfire”. They added that if negative interest rates work, they may start a new era for central banks worldwide. The decision of Japan on January 28 came one-and-a-half years after the ECB became the first major central bank to cut interest rates below zero.

On December 3, the ECB cut a key rate further below although the bank’s president, Mario Draghi, had said earlier that it had hit the “lower band”. The authors noted that by the end of 2015 about a third of the debt issued by Euro Zone governments had negative yields.

That means investors holding to maturity won’t get all their money back.

While banks have been reluctant to pass on negative rates for fear of losing customers, the Julius Baer Group Ltd, Switzerland’s third largest wealth manager, is passing on the central bank’s negative interest rates to its institutional customers like pension funds which use Julius Baer for custody services. Julius Baer will decide at a “later stage” about passing on negative rates to its private clients whose deposits stood at 396 billion francs or $416 billion under its management at the end of 2014.

Banks including UBS Group AG, Credit Suisse Group AG and J Safra Sarasin Holding AG have already levied charges on some cash accounts after the Swiss National Bank started charging 0.75 per cent interest to hold francs.

In the final analysis, negative interest rate seems to be spreading like an epidemic and before the end of 2016 several more countries are likely to go negative.

One should keenly watch the decision of the US Fed. If it were to blink our entire concept of banking could be expected to undergo a “sea change into something rich and strange”. Low interest rate is bound to spur growth and it is advisable to rely on interest rate policy rather than exchange rate mechanism to spur growth in the economy.

The writer was with the IMF

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