Paying to save
Negative interest rates are no panacea – but they may be inevitable
When Andrew Bailey stepped up to become Governor of the Bank of England six months ago, he was emphatic about the prospect of negative interest rates in Britain. “On the whole, negative interest rates, no … it is not an area I would want to go to.”
Fast forward to last week’s ratesetting meeting on Threadneedle Street and the odds of a base rate below zero look shorter. The monetary policy committee has been briefed on how negative rates could work in practice and what steps could be taken to minimise the most damaging sideeffects. The drop in the value of the pound said it all. It looks like when, not if, we follow Europe and Japan below the zero bound, maybe not this year but probably in 2021.
The difference between March and September can be measured on three fronts: Covid-19 looks no better than it did in the spring if speculation about a half-term lockdown is anything to go by; the economy is looking into the abyss of a post-furlough employment crisis; meanwhile, a no-deal Brexit appears close to inevitable come January.
This unpalatable cocktail makes it likely that Britain will pip America to the post when it comes to negative rates, but the Federal Reserve is also one small step away from crossing the interest Rubicon. Jay Powell last week kicked the next upturn in rates even further into the long grass, to the end of 2023 at least. Donald Trump, if he is returned as president in November, will keep banging his Twitter drum for the “GIFT of negative rates”.
If we do go down that path, we at least have the advantage of having seen how the experiment has worked out across the channel since rates fell below zero in Europe in 2014 and Japan two years later. Overall, things have turned out a bit better than the negative rate sceptics suggested they might. Bank lending picked up in Europe and unemployment fell. The region’s deflationary spiral was arrested. The sale of safes may have briefly risen, but savers didn’t stuff cash under the mattress. A reduction in bad loans helped banks offset the squeeze on margins that low rates, positive or negative, imply.
Sweden may have called time on its five-year dalliance with negative rates, but the ECB’s hope that going below zero would show it had not run out of ammunition has, so far, been justified.
There are, nonetheless, plenty of good reasons not to like negative rates. In the US, there is firstly the consideration that they might not even be legal. A 2006 law that allows the Fed to pay interest to banks talks about depositors “receiving earnings” and doesn’t even mention the possibility of levying a charge instead. The US also has around $4trn tied up in money market funds, short-term debts that many investors treat as a proxy for a cash deposit account. Not getting your capital back in full, “breaking the buck” in the jargon, came close to causing a panic in 2008 during the financial crisis.
But the main problem with negative rates is that there is scant evidence that they actually work in the way intended, by boosting confidence and increasing economic activity. One reason for this is that there appears to be a so-called “reversal” rate of interest below which people are not encouraged to borrow and spend more but are instead spooked into precautionary savings. Some economists argue that very low or negative interest rates lead to low inflation, because they encourage the self-fulfilling expectation that prices will fall.
A further reason to be cautious is that there is a limit on the extent to which banks can pass on negative rates to their customers. Most will not pass on a penalty interest charge. At the same time, the amount they can charge on loans is reduced. Their profits are squeezed, and they consequently reduce the amount of available credit at precisely the time when the economy needs it to be increased.
One last argument not to go down the negative rates path is the impact it could have on already damaging levels of inequality as “free” money finds its way into asset markets, housing in particular. Denmark has introduced mortgages that reduce the amount of capital owed by a small amount each month. Low rates unavoidably encourage excessive risk-taking.
The implications for other investments are also largely untested. Given the need for bond yields to offer investors a yield premium, however small, over cash, there might be a practical downside limit to long bond yields and so an upside limit to their price. This might make them ineffective as a hedge against the volatility of shares. The impact on the dollar might, contrary to expectations, be to increase its safe-haven value. At the very least, it might encourage investors into riskier or more illiquid assets in their desperate search for yield. It certainly makes banks a less attractive investment, threatening the stability of the financial system.
So, negative interest rates are no panacea. But as we move closer towards a cashless society, the constraints on central banks employing this last throw of the monetary dice are reduced. There is a kind of inevitability about them, I think, unless politicians accept the role that government spending must play in a better-balanced support operation.
It is easier with fiscal policy to target those who most need the stimulus and are more likely to spend it rather than simply enjoy the positive impact it has on their wealth.
‘The main problem with negative rates is that there is scant evidence that they actually work in the way intended’
Tom Stevenson is an investment director at Fidelity International. The views are his own. He tweets at @tomstevenson63
Andrew Bailey, the Bank of England Governor, could yet change his mind on negative interest rates