23 Aug 2019
Shakespeare would have struggled with negative interest rates. What would Shylock have done in the Merchant of Venice? Hand Antonio a pound of his own flesh rather than demand a pound of Antonio’s in interest?
Rigorous historian though he was, negative interest rates were not something in Shakespeare’s ken.
"As investors (including banks) search for yield, the bidding for higher yield assets becomes more intense - meaning riskier loans are made at prices not reflecting the chance of loss.”
According to John Hawkins, assistant professor at the University of Canberra, negative rates are extremely rare.
“Even rates as low as 1 per cent are historically unusual,” he wrote in The Conversation. “In his epic study of interest rates, A History of Interest Rates (1963), author Sidney Homer suggests rates lower than 3 per cent were virtually unknown in ancient Mesopotamia, Greece or Rome. Or in medieval and renaissance Europe.”
Negative interest rates do have a Through the Looking Glass feel but in theory the concept is not difficult: when you lend someone money, typically you expect more money when the loan is repaid - the principal plus the interest. The interest covers the risk.
When we make a deposit, we are lending money to a bank. So a negative rate means the bank actually pays us back less than we deposited. Not a great outcome - but that’s the intention: deter those with capital from simply depositing it and instead encourage them to invest on the hope of a better return.
That’s the theory. But there are myriad complexities, not least of which is the established body of economic rules begin to break down when interest rates are so low for so long.
For example, John Taylor, creator of one of the most widely used central banking dicta, the Taylor Rule, concedes the rule needs a rethink as global rates approach their “zero-bound”.
Speaking on the sidelines of the recent central banker gabfest in Jackson Hole in the US, Taylor said his rule - which sets short-term interest rates against an inflation target and full employment - was still relevant but near zero interest rates had wide implications for capital flows, currency levels and cross-border anomalies.
There are actually physical challenges too with negative rates. Few financial institution technology platforms are designed to accept negative rates. The computer will just say “no” when a negative interest rate is input.
(There are work arounds - the rate can be zero and a discount on the principal is applied at the end but that’s hardly a sustainable solution.)
This current era of negative interest rates kicked off in 2014 when the European Central Bank (ECB), in an attempt to coerce banks into lending more to stimulate the economy, made banks pay for the deposits they held with the central bank.
Ideally, this would have driven more lending and more investment by companies who could borrow at lower rates, creating jobs and inflationary pressures which in turn would force up interest rates.
It hasn’t happened. More central banks have turned to negative rates together with abnormal policy actions such as quantitative easing (essentially allowing governments to print money which should also, according to the old rules, be inflationary.) Yet inflation remains stubbornly low across the developed world - including in traditionally higher inflation economies like Australia.
This perhaps shouldn’t have been that unexpected. Twenty years ago the Bank of Japan (BOJ) tried the same tactic, pushing official rates to zero. Inflation has barely budged.
Meanwhile, according to ratings agency Fitch, annual economic growth rates have been falling since mid-2018 in virtually all of the 20 large developed and emerging economies covered in the agencies major economic research.
“Annual growth in the US has been declining since mid-2018, in line with the pattern seen in China, the Eurozone and virtually all other large economies,” according to Fitch.
Even though the efficacy of the treatment is yet to be evident, the side effects are real. Like them or loathe them, banks remain the key intermediaries of finance. The ECB’s - less than successful - negative rates and the lower rate regime in general squeezes bank profitability.
That’s because while the rates banks are paid on their assets - loans - falls, the rates banks pay on their liabilities - deposits - can’t fall as far. Again that’s because there is simply no accepted way to set negative interest rates on savings and deposits.
That squeeze on margins in aggregate can stifle financing of the real economy.
Moreover, as investors (including banks) search for yield, the bidding for higher yield assets becomes more intense - meaning riskier loans are made at prices not reflecting the chance of loss.
Exactly this happened in the run up to the global financial crisis.
At the time, Bill Gross of Pimco, the world's largest fixed-interest fund, pointed out the interest-rate premium paid by riskier credits was not matched by the chance of that credit failing.
"When the premium paid for the riskiest debt is only 2.5 percentage points over the safest and the historic default rate of that debt is 5 per cent, and about 60 per cent of the principal is lost in a default, any loan made at the rates prevailing [in 2006] would lose 3 per cent over the life of the loan. High-yield lenders were giving away money."
Even more so with negative rates: the investor is guaranteed to lose money. The calculus is less money will be lost than with alternatives. Or indeed - as occurred in the financial crisis - the high-risk debt becomes the vehicle for a game of pass the parcel.
Banks also undertake another vital function in the economy, what’s known as “maturity transformation”. They borrow for short periods of time and lend for longer periods - the risk justified in normal times when longer term rates are higher than shorter term ones.
Indeed, after the US savings and loan financial crisis in the 80s, a fundamental element of restoring the system (at minimal cost to tax payers) was the ability of banks to trade off the steepness of the yield curve while inflation ate away at the value of debts.
Today, with negative rates and expectations of long term ultra-low rates, coupled with the Trump trade war and other geopolitical traumas, the yield curve is “negative” - long term rates are lower than short term ones. That removes the incentive for maturity transformation.
Economic rules are not like the laws of physics (and obviously even those break down in extreme circumstances as Einstein proved).
For example, Japan has managed to invert the traditional correlation between lower rates and higher inflation. When Japan announced its negative rate policy, inflation expectations actually fell, according to research by the San Francisco Federal Reserve.
“Our market-based estimates indicate that, when the BOJ announced its plan to move to negative policy rates, inflation expectations actually declined and then continued to trend downward afterward,” the SF Fed said. “Therefore, Japan’s case is an extreme but potentially informative example illustrating the challenges associated with raising well-anchored inflation expectations through negative monetary policy rates.”
Stimulating demand has been a challenge in Japan for decades now, increasingly it is more globally an issue. As Bank of England Governor Mark Carney put it “as the global equilibrium rate falls, it becomes more difficult for domestic monetary policymakers everywhere to provide the stimulus necessary to achieve their objectives”.
This is what economists refer to as the futility of “pushing on a string”.
But with negative rates and the collateral impacts on the real economy, a better aphorism might be “the beatings will continue until morale improves”.
Andrew Cornell is managing editor of bluenotes
The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.
23 Aug 2019
10 Jul 2019