3 long-term con­se­quences of neg­a­tive rates

The Pak Banker - - OPINION - Mo­hamed A. El-Erian

MOST econ­o­mists are tempted to rely on in­cre­men­tal anal­y­sis to ex­plain the spread of neg­a­tive in­ter­est rates and their im­pli­ca­tions for the global econ­omy and mar­kets. This is un­der­stand­able, yet the in­cli­na­tion to fo­cus pri­mar­ily on mar­ginal changes could be overly par­tial and even mis­lead­ing -- es­pe­cially for mar­ket par­tic­i­pants who must nav­i­gate the un­in­tended con­se­quences of sub-zero yields, in­clud­ing the pos­si­bil­ity of "tip­ping" events.

The con­ven­tional ar­gu­ment of econ­o­mists goes some­thing like this: The ac­tions of cen­tral banks and the mar­ket pric­ing of gov­ern­ment bond yields have proved that zero no longer con­sti­tutes a lower nom­i­nal bound for in­ter­est rates.

As a re­sult, the ef­fects of neg­a­tive rates are best an­a­lyzed in terms of deltas -- that is to say, by ex­trap­o­lat­ing the mar­ginal im­pact of a change in rates (say from mi­nus 0.2 per­cent to mi­nus 0.3 per­cent), as op­posed to as­sess­ing lev­els as a whole (how neg­a­tive and for how long). De­spite the his­tor­i­cal anom­aly of neg­a­tive nom­i­nal rates, most econ­o­mists are in­clined to ap­ply the tra­di­tional anal­y­sis of a con­tin­uum of pric­ing, be­hav­iors and eco­nomic ef­fects.

I am not so sure that this nec­es­sar­ily is the right ap­proach. Three de­vel­op­ments on the ground sup­port this skep­ti­cism and sug­gest the need for more open think­ing and anal­y­sis: First, much of the in­sti­tu­tional setup for pro­vid­ing fi­nan­cial ser­vices to millions in sys­tem­i­cally im­por­tant ad­vanced economies was not de­signed to op­er­ate for long with neg­a­tive nom­i­nal in­ter­est rates, and with the as­so­ci­ated flat­ten­ing of the yield curve. For ex­am­ple, with pres­sures on net in­ter­est mar­gins, banks face greater chal­lenges in in­ter­me­di­at­ing funds and are in­creas­ingly in­clined to turn away de­posits. More­over, providers of long-term fi­nan­cial sav­ings, pro­tec­tion and as­sur­ances -- from pen­sion funds to in­surance com­pa­nies -- find it harder to meet client ex­pec­ta­tions of mean­ing­ful safe re­turns many years in the fu­ture. There are no mean­ing­ful sub­sti­tutes avail­able in the short-term.

Sec­ond, per­sis­tent neg­a­tive in­ter­est rates may com­pel a grow­ing num­ber of in­di­vid­u­als to dis­en­gage from a fi­nan­cial sys­tem that now taxes them for plac­ing de­posits and sav­ings. No won­der the sales of home safes soared in Ja­pan af­ter the Bank of Ja­pan un­ex­pect­edly de­cided to fol­low the Euro­pean Cen­tral Bank into neg­a­tive pol­icy rate ter­rain.

The longer these two sets of cir­cum­stances pre­vail, the greater the pres­sure on in­di­vid­u­als and com­pa­nies to self- in­sure rather than rely on the sys­tem's col­lec­tive in­surance fa­cil­i­ties. In turn, that risks trans­lat­ing into slower eco­nomic ac­tiv­ity, as well as more frag­mented fi­nan­cial mar­kets that are harder to mon­i­tor, in­flu­ence and reg­u­late.

Third, if neg­a­tive in­ter­est rates go be­yond per­ceived thresh­olds of rea­son­able­ness and sus­tain­abil­ity, the op­er­at­ing modal­i­ties of cer­tain mar­kets could change. This dy­namic may be play­ing out in the re­cent puz­zling be­hav­ior of for­eign-ex­change mar­kets af­ter both the Bank of Ja­pan and the ECB adopted and re­in­forced their neg­a­tive rates pol­icy.

Rather than de­pre­ci­ate, both the yen and the euro have ap­pre­ci­ated. Al­though some of these coun­ter­in­tu­itive moves re­flect a some- what more dovish Fed­eral Re­serve, which has mit­i­gated ex­pec­ta­tions of highly diver­gent in­ter­est rates among the world's cen­tral banks, there could well be some­thing big­ger in play: Specif­i­cally, the di­lu­tion of in­ter­e­strate dif­fer­en­tials as the main driver of cur­rency val­ues, par­tic­u­larly as greater at­ten­tion is paid to stock ef­fects, in­clud­ing the abil­ity of cit­i­zens to repa­tri­ate cap­i­tal from abroad. This is an espe­cial con­cern for Ja­pan.

All this calls for fur­ther anal­y­sis and more open- mind­ed­ness from econ­o­mists when as­sess­ing how the global eco­nomic and fi­nan­cial sys­tem is likely to op­er­ate now that about one-third of global gov­ern­ment debt is trad­ing at neg­a­tive nom­i­nal yields. Specif­i­cally, stock ef­fects and be­hav­ioral in­flu­ences could al­ter the con­clu­sions that are de­rived from an anal­y­sis based pri­mar­ily on in­ter­est-rate dif­fer­en­tials and other rel­a­tive pric­ing con­sid­er­a­tions.

Should this prove to be the case, and I sus­pect it will, the im­pli­ca­tions for in­vestors and traders would go well be­yond the po­ten­tial of a new set of un­in­tended and un­usual po­ten­tial head­winds to eco­nomic growth and cor­po­rate earn­ings. The new un­der­stand­ing would re­quire al­ter­ing pric­ing mod­els for for­eign-ex­change mar­kets, re­cast­ing as­sump­tions about cor­re­la­tions among dif­fer­ent as­set classes, be­ing more open to the pos­si­bil­ity of sud­den mar­ket jumps and air pock­ets, and fac­tor­ing in a larger liq­uid­ity risk premium.

Newspapers in English

Newspapers from Pakistan

© PressReader. All rights reserved.