Negative thinking…

Since 29 January Japan has joined the club (no longer so exclusive) of central banks offering negative rates of interest. After Denmark, Sweden, the euro zone and Switzerland, Japan is now offering a maximum rate of -0.10% on deposits that it receives. In a few days the ECB may decide to lower its rate further, to as low as -0.50%...

Welcome to the brave new world of the financial economy.

Just a few years ago, classical economists regarded interest rates as the saver’s reward for foregoing consumption. As the future is uncertain and as human beings are impatient, the saver, it was felt, should receive interest on his savings. But we are all Keynesians now and interest rates have also become a factor in adjusting counter-cyclical policies. So rate cuts are thought to encourage savers to consume more. Almost one century has gone by since the Keynesian theories… and the world has now embarked on a new revolution – negative rates. You now have to pay to deposit your money! Never has the saver been penalised so much by this indirect tax in the form of negative rates. Never has the borrower paid so little interest.

How did we end up here?

This race to the bottom has not been without reason. Faced with the spectre of deflation, central banks the world over are in an all-out rush to lower the cost of servicing public debt, to restart lending to the private sector, and to depreciate their currencies. Mission accomplished for the first objective, as governments have never borrowed at such low rates, and that has helped them rein in their deficits. As a result, debt-servicing costs in the euro zone have fallen in two years from 2.90% of GDP to 2.50%. However, the impact on private-sector lending has been less clear. In Switzerland and Denmark lending to households actually slowed after the introduction of negative rates. In Sweden and the euro zone, however, lending appears to have picked up somewhat. Ultimately, the biggest impact that negative rates have had has been in depreciating currencies. With the exception of Japan, lower rates have weakened currencies further vs. those of their main trading partners.

Nasty side-effects

Beyond these good intentions, negative rates could have some nasty side-effects. The banking sector, for example, appears to have been hard hit so far this year by serious concerns regarding negative rates. Clearly, net income is in structural decline at European, Swiss and Danish banks and the recent rate cut could exacerbate the damage to their margins.

On the bond markets, recent central bank actions have led to a massive drop in yields. Almost 8 trillion euros in government debt is now trading at negative rates, which is making bond markets vulnerable to volatility and liquidity shocks. It would be presumptuous to suggest that the central banks have full control over the situation.

And then there is the risk of a bank run. Below a certain level of interest (which we estimate at about -1.00%) there is a risk that savers will withdraw liquidity, leading to a conversion of bank deposits into cash. This would constitute a clear systemic risk for banks.

So what are we to make of all this?

While such a policy’s drawbacks now appear to be balanced with its advantages, there is another conclusion to be drawn: the central banks are now running low on ammunition. Rates can hardly get any lower than they already are, and their impact will henceforth be only marginal. We are far removed from the era of “whatever it takes” (2012), when the ECB’s power peaked. Three and a half years later, inflation expectations are at an all-time low in Europe; banking shares have taken a beating; and the euro is up slightly. Monetary authorities have run out of options and power is slipping out of their hands. On the eve of a crucial ECB meeting and with expectations running high, the ECB will, above all, have to avoid disappointing and do what it can to counter this negative thinking. So good luck, Mr Draghi!