The spectre of negative interest rates is looming over Anglo-Saxon markets.
Last month, the UK sold three-year debt at a negative yield for the first time. The Bank of England said the option of pushing benchmark interest rates below zero was under "active review", as it also is in New Zealand. And in the US, the market is starting to price in this possibility from next year.
Conventional thinking is that negative policy rates — which are in place in the eurozone, Japan and elsewhere — are just a natural continuation of central banks' vast bond-buying programmes. But this underestimates how financial intermediaries may respond to such a move and its impact on inflation expectations.
A move below zero would be an unwelcome and unnecessary experiment for markets, for three reasons.
First, the evidence that negative policy rates have successfully generated growth or inflation is weak. Financial conditions appear to improve, at first. But several recent papers highlight that low rates correlate with low inflation, perhaps because they cause longer-term expectations of price rises to weaken, rather than strengthen. It is also debatable whether negative rates have an impact on inflation through the channel of exchange rates, as currencies depreciate.
Second, the financial frictions of negative rates may be more severe in UK and the US. As professor Charles Goodhart and I have argued before in these pages, macroeconomic models typically take banks and other intermediaries for granted. But negative rates erode the profitability of banks, possibly reducing the availability of credit in the economy at a time when banks' resilience is much needed.
They could also weaken crucial short-term debt markets. The US$5 trillion ($7.8t) US money-market fund sector, which was a trip wire of the financial crisis in 2008, would surely be at risk.
To overcome some of these challenges, significant regulatory changes would be needed to reduce the risks to banks and money-market funds. But the politics of insulating institutions from negative rates cannot be taken as a given. It took the European Central Bank five years to introduce a tiered interest rate regime, for example, under which some of banks' deposits are exempted from the negative rate.
Third, even the proponents of negative rates admit there is a point where the policy does more harm than good. According to economists Markus Brunnermeier and Yann Koby, this "reversal rate" varies according to the characteristics of a particular banking system, but also changes over time, so central bankers would need to tread gingerly. A measure requiring such extreme caution is not one well suited to confront emergency conditions.
Thus far, the Federal Reserve, like the BoE, has judged that negative interest rates are not an "attractive" policy tool. But the view has become more nuanced on both sides of the Atlantic, with the Fed saying it is not considering negative rates "for now".
But if the economy were in a prolonged recession from the pandemic aftershock, all measures to boost aggregate demand would be on the table — especially if fiscal policy were constrained by politics, or the rising size of sovereign debt burdens.
Another important but overlooked factor is the reduction in the use of cash. Academic supporters of negative rates have long argued that this would need to happen for negative rates to be pushed much below minus 1 per cent.
Covid-19 is now prompting a shift to contactless payment and online trading, which could give policymakers grounds to argue that negative rates could be implemented with less risk.
For investors, all this is another reason to steer clear of the banking sector. Many lenders are already trading at rock-bottom prices for fear of huge credit losses, weaker earnings and low or no dividends. Smaller banks would suffer most.
Moreover, a 2018 report by the Bank for International Settlements argued that the solvency of insurers and pension funds would be a larger concern than that of banks, in a scenario of very low rates for very long periods. Many insurers have so far followed a "barbell" investment strategy with government bonds at one end and large exposures to riskier corporate debt at the other — both of which could be under pressure in a negative rate situation.
The debate over negative rates will be kept alive by concerns that countries' economic-policy arsenals are insufficient to deal with the effects of the Covid-19 crisis. But many investors will be hoping central banks stick to more conventional unconventional measures such as bond-buying, forward guidance and yield curve control, alongside fiscal policy. If policymakers overlook the risks of negative rates to the financial sector, central bankers could be hurting more than they are helping.
- The writer is chair of the sustainable finance committee at UBS.
Written by: Huw van Steenis
© Financial Times