The wisdom of negative interest rates came up several times during the World Economic Forum in Davos last week. Jamie Dimon (CEO, JP Morgan) shared his views (see CNBC); as did Larry Kudlow, Director of the National Economic Council in the Trump Administration (see Yahoo Finance link); Christian Sewing, CEO of Deutsche, (Reuters link here); David Solomon, CEO of Goldman Sachs; Ana Botin, Executive Chairman of Santander; and Ralph Hammers, CEO of ING. All of these professionals expressed concerns with the unconventional central bank approach of negative interest rates, which have been used in Sweden since 2009 (until recently), the Eurozone since 2014, Switzerland since 2015, and Japan since 2016. Of course, although not negative, one can also see the effect of prolonged historically low short-term interest rates in the U.S. and U.K. (albeit BREXIT-affected). These abnormally low – or negative – short-term interest rate policies – often referred to as “zero bound” - were born out of the severe economic downturn extending from late 2007 to early 2009, known as the “Great Recession”. More and more questions are being raised about the effectiveness of negative interest rates since the hoped-for economic stimulus has yet to materialise in several of the countries / economic blocs that turned to this unconventional approach to stimulate economic growth. In particular, the Eurozone and Japan are still experiencing lacklustre growth and very low inflation, occasionally flirting with deflation. Probably most concerning to many, as highlighted in some of the links in the opening part of this paragraph, is the Eurozone. Christine Lagarde, the new President of the European Central Bank, is “buying time” as the ECB undertakes a strategic review (see FT article), but has announced that the central bank intends to stick to its negative interest rate approach for the time being. Only time will tell where this economic bloc ends up as far as continuing with its current interest rate strategy, as the Eurozone is unique in that it is burdened by a number of other non-monetary policies that are undoubtedly hindering its recovery.
Quantitative Easing (“QE”) is another unconventional monetary policy tool used since the Great Recession in several economies, and this cannot be completely untangled from the policy tool of negative short-term interest rates. Like ultra-low to negative short-term interest rates, QE was also a product of the Great Recession that was introduced by select central banks in an effort to lower intermediate and longer term yields by flattening the curve and lowering borrowing costs across all maturities. The purpose of QE was the same as with lowering over-night borrowing rates - to stimulate economic growth. Many economists believe that QE is well beyond the mandate of central banks, but this discussion is for another day (or another post). This post is principally focused on the rate set by central banks to influence short-term overnight bank-to-bank lending or deposits with the central bank, rather than quantitative easing.
The short-term policy rate set by central banks varies by country:
U.S.: it’s known as the Fed Funds rate (target range currently 1.50%-1.75),
U.K.: referred to as the base rate (currently 0.75%),
Eurozone: the main reference rate is the deposit facility rate (currently -0.50%), and
Japan: generally referred to as the short-term interest rate target (currently -0.10%).
Of course, having to pay the central bank to hold overnight liquidity when rates are negative is a very real cost to banks, estimated for example to be around €7.5 bln / annum for Eurozone banks (source: Bloomberg). This means that negative rates can cut both ways. On one hand, negative rates should encourage banks to hold the absolute minimum amount of excess reserves, promoting lending. On the other hand, negative rates incur a very real cost and drag on profitability on banks that choose to hold excess reserves to ensure they have ample liquidity on hand. Because of the cost of negative rates, several central banks (Eurozone, Japan and Switzerland for example) have introduced “tiering”, which allows banks to hold a multiple of required excess reserves at a rate of 0% (rather than a negative rate), after which the negative rate starts to apply to incremental reserves. In the case of the ECB, this threshold - introduced on October 30, 2019 - is six times the minimum reserve requirement, meaning that Eurozone banks only pay negative interest rates on amounts in excess of this level of reserves.
Perhaps we should start by looking at why the level of overnight interest rates set by a country’s central bank matters in an economy. From a demand perspective, individuals and businesses are more likely to borrow to finance investment – say purchase a car or a house (individuals), or invest in new machines or factories (businesses) – when the cost of borrowing is low. Higher spending in an economy stimulates economic growth, lowering unemployment and raising incomes. From a supply perspective, banks will be less likely to hold excess reserves if the interest they earn on the excess cash is low compared to what they would earn lending to the “real economy.” Therefore, lower rates on overnight deposits should spur more lending rather than hoarding case. Negative interest rates are an extreme example of this; theoretically, banks get back less than they deposit overnight and therefore should be very eager to lend money or invest in higher yielding assets, rather than hold reserves. This is well-known and understood macroeconomic theory, but the reality is that the Great Recession changed the mindset of banks, individuals and businesses. Let’s talk about the banks first, which determine the supply of loans.
There’s little debate that without significant government intervention during the Great Recession, there would have been many more banks that would have failed because of escalating systemic risk in the banking system. And the banking system of every country is its financial backbone. Concerns about the solvency of a country’s banking system are highly contagious - no one wants to be the person that is left with no savings because others withdrew their savings first. Fortunately, the banking casualties during the Great Recession were limited because of government intervention in the form of specific actions, namely the provision of unlimited liquidity to banks, the creation of good banks-bad banks, and the eventual recapitalisation of “Too Big to Fail” banks in many major economies, including the U.S. and the U.K. For governments that were aggressive in ensuring that their banks cleaned up their portfolios by writing down or disposing of impaired assets, the result was that banks in these countries eventually recovered and – in some cases – flourished. In other places, including several continental European countries (and similar to Japan in the 1990’s), governments did not act aggressively enough to ensure that their national banks cleaned up their bad loan portfolios. The result was that a number of banks were allowed to continue to operate when they were perhaps technically insolvent, and the presence of these “zombie banks” contaminated – and has continued to impede - the banking system in that country. It’s this simple – governments that were aggressive and acted decisively to address issues in their banking system, alongside accommodative monetary and fiscal stimulus, helped restore confidence in what was then a fragile banking system, setting the stage for a gradual recovery in these economies. In countries / economic blocs where the banking system is viewed as fragile, many of the banks still hoard excess liquidity - even if it comes at a cost - to protect against a potential depositor “run on the bank”, a death knell. Over-night rates, even if negative, cannot overcome the survival instinct to protect against a bank run.
From a demand perspective, consumers and businesses that held financial assets or were investing in new production lost money during the Great Recession, whether it was on their houses, 401ks, other equity or bond investments (consumers), or on revenues that failed to materialise on new production lines or factories (businesses). People saw very meaningful portions of their net worth vaporise quickly, and this undoubtedly left impressions that lasted a long time. Of course, the more you were able to weather this storm, the more opportunity was available as the recovery gained steam, and this has led to dramatic increases in wealth inequality – I’ll come back to this topic later. But as monetary policy became super-accommodative and rates plummeted to zero or below, people and businesses remained reluctant to borrow because of the pain they had just experienced, and because of the on-going uncertainty about the strength of the economic recovery and the future generally. Still, such policies in coordination with fiscal stimulus and regulatory reform eventually restored confidence, and those economies that acknowledged the severity of the Great Recession with an aggressive and decisive approach were rewarded with a recovery even if it was erratic in its initial stages.
In other words, “you can lead a horse to water, but you cannot make him drink” is very true in places like Japan and the Eurozone. The central banks simply cannot manufacture an economic recovery in isolation, no matter how unconventional and accommodative they might be. Even with negative rates, many banks will hold excess liquidity, and consumer and business demand will remain muted because confidence in the future of the economy is low. In the case of the Eurozone, accommodative monetary policy by the ECB will fail on its own without significant structural reforms and some form of fiscal stimulus. The risk of the “Japanification” of Europe is very real.
Let’s return to the specific topic of this post - the concerns with and distortions caused by “zero bound” - or negative - interest rate policies: “What sorts of distortions have been caused by negative interest rates?” “What are the long-term effects of negative interest rates?” “How can negative interest rates be reversed without damaging economic growth?” My thoughts on these questions are below.
1. Negative (or ultra-low) interest rates cause asset bubbles: I am not going to go deeply into this, but the logic is simple - the cheaper that money is, the more that leverage can be used by those able to obtain it to purchase higher yielding financial assets. And this in turn starts the vicious cycle of borrowing cheaply to finance higher yielding financial assets and then having the financial assets appreciate because more investors are buying them. This then triggers another cycle of incremental borrowing against these inflated financial assets to buy more, and so forth. Also of course, as investors become increasingly confident that assets will only appreciate, they get more and more aggressive, piling into appreciating assets as they go higher and higher (even without using cheap money to leverage). These are a couple of the reasons why you are reading more and more about asset bubbles fuelled by overly-accommodative monetary policy.
2. Negative (or ultra-low) interest rates exacerbate inequality: As mentioned in my first point above, ultra-low or negative interest rates tend to benefit financial assets like real estate, stocks and bonds, and the holders of these assets tend to be skewed towards those with wealth. Although the U.S. does not have negative rates, its ultra-low interest rate policy (compared to historical levels) has provided the most visible example of deteriorating income inequality mainly because the country has experienced strong relative economic growth and the U.S. stock market has performed accordingly. Let’s look at this more closely. The percentage of U.S. adults invested in the stock market is around 55%, below the high of 63% in 2004 but above the post-recession low of 52% in 2013. The return on the S&P 500 since the beginning of 2009 has been around 12.5% / annum. Compare this with bank savings rates of 1% / annum (if you’re lucky), and this metric alone – as simple as it is – helps to explain why people in the U.S. with wealth and financial acumen (or access to financial advisors) have gotten even wealthier, whilst those with little to no wealth have not.
The trend since the late 1980’s is illustrated in the graph below.
As this table illustrates, the top 1% of earners (red line) has accounted for more and more of aggregate wealth since the Great Recession, at the expense of the other 99% of earners. The next 49% (the 90%-99% and the 50%-90% blocks, the yellow and grey lines, respectively) has experienced declining wealth, slightly surprising to me in that this includes the very wealthy 90-99% block. And even though the bottom 50% of earners (blue line) has had their relative percentage of wealth increase since the Great Recession, it has hardly moved the needle as far as aggregate wealth because their share of overall wealth is so low.
Complementing this graph, the table to the left shows how savings is distributed by income levels of households in the U.S. It shows that the top 1% of earners have 2.6x the wealth of the top 10%, but that the next tier of earners (70%-90%) has only around 15% of the wealth of the top 10% (top quartile of table). And things get worse quickly from there as you can see.
Wealth inequality has been less in the Eurozone and Japan based on data I have reviewed, but this is most likely a reflection of the superior growth in the U.S. economy and related returns of the U.S. equity markets and other financial assets since 2009 compared to the U.K. (FTSE), Europe (STOXX 600) and Japan (Nikkei 225), even though the latter two have negative overnight borrowing rates.
3. Efficacy of rates fades over time – Over time, the “message” in the actual level of the over-night bank deposit rate means less whilst the directional bias provides more signalling value about the future of an economy. Changes by central banks in short-term rates are also a trailing indicator. Central banks tend to raise rates when the economy is trending towards over-heating (low employment, robust growth and / or inflationary pressures) or lower rates when a recession might be on the horizon (unemployment is increasing, economic growth slowing and / or low inflation or deflationary pressures). For example, the U.S. Federal Reserve lowered interest rates to 0% in December 2008, and the nominal GDP/annum until the Fed started raising interest rates again in December 2015 averaged 3.5% / annum. But when the Fed started raising rates again, nominal GDP growth averaged 4.1% / annum even though the Fed was systematically raising the overnight borrowing rate from late 2015 until mid-2019. (The Fed reversed course in 3Q2019 and started lowering rates again, responding to slowing GDP growth.)
4. Monetary tools effectiveness diminished / depleted – Once a central bank has unleashed unconventional accommodative monetary policies, especially a combination of negative interest rates and quantitative easing, it will have few if any policy tools left in its arsenal to provide stimulus to address a future downturn. This is not where a central bank wants to be, but it is exactly where many central banks find themselves today.
5. Unwinding / reversing the policy – Sooner or later we will arrive to the time of the “great unknown” when central banks will have to reverse course and unwind their sustained period of accommodative policies, including ultra-low / negative interest rates and / or quantitative easing. No one is sure how long this will take, but one thing is for sure – the unwind is unlikely to be a response to overly robust economic growth, because many of the world’s larger economies remain stuck in a low growth, low inflation funk in spite of the use of aggressive central bank policy tools over many years.
Negative interest rates were perhaps needed (along with quantitative easing) in the darkest days of the Great Recession, but only to unleash unprecedented liquidity in the market that – alongside fiscal policy stimulus and regulatory (mainly bank) reform – would be powerful enough to restore confidence in the economy and put the banking system on firmer footing. Through a combination of central bank and government policy tools, countries needed to encourage consumers to spend and businesses to invest. However, if the cocktail to reverse this trend is not a coordinated and a powerful approach across monetary, fiscal and regulatory policy, this dangerous cycle will not be broken. The outcome, as we are seeing, is a continuation of mundane economic performance, and the longer this persists, the more difficult the cycle will be to break. Governments need to step in with fiscal stimulus and regulatory reform whilst central banks attempt to normalise their approach to overnight bank borrowing costs. In the Eurozone, there is too much regulation and too many under-performing banks. To encourage business, the winners need to be given the runway to succeed, and – as painful short-term as this may be – the poorer performing banks (even “national champions”) should be cleaned up, wound down or merged into other banks that are better managed. People will lose jobs, both in the private sector and the public sector (imagine less regulators), but this is the cost to get poorly performing economies back on track. Central banks cannot do it on their own, and we are seeing this play out right now especially in the Eurozone.