Central banks in developed economies face a strange monetary reality. Since the Global Financial Crisis, much of what economists thought they understood about inflation and economic growth no longer applies. The apparent link between low unemployment and inflation seems to have disappeared and the prolonged low interest rates of the past 12 years have been futile in promoting inflation. This unprecedented situation has resulted in a monetary development that is no less mysterious: the emergence of negative nominal interest rates.
Negative nominal rates mean that private banks are charged for storing money in the central bank, a cost that private banks have only passed on to their large-sum depositors and savers (so far). It also means that government bonds issued with negative returns will result in bondholders receiving a total amount of interest below the price they paid for this debt. Simply, it is a reversal of the norm where creditors receive cashflows from debtors.
As it stands, about 30% of all global investment grade government debt yields negative nominal returns. Moreover, private banks in 19 out of the 29 developed countries experience a charge when depositing money in their central bank. What are the implications of this? Why are investors still buying these bonds? And why are banks private banks still depositing money? We cannot be entirely sure for how long they will continue in force, but the prevalence of negative interest rates today has likely been exacerbated by the combination of accommodative central banking policy and uncertainty in investor expectations.
After the Financial Crisis, central banks began lowering yields on debt and fund rates as well as purchasing mass amounts of government and corporate debt in a process known as Quantitative Easing. The goal was to stimulate economic activity and growth by fomenting lending by commercial banks and spending by consumers. When this failed to have a prolonged impact as a result of private banks hoarding cash to repair their balance sheets, overnight deposit rates became negative and eventually, so did yield rates on government debt.
Unexpectedly, the market’s reaction to these policies contradicted central banks’ expectations. Evidence shows that in Japan and many European countries savings rates have increased or remained the same. Research suggests that the pessimism of a negative interest rate economy instilled the expectation of economic contraction, deflation, and potentially lower negative rates, making investing at a slight loss somewhat attractive. Investors would rather secure a marginal loss today if they believed rates would become more negative in the future. Furthermore, if deflation were significant, investors would actually benefit from saving at a loss rather than spending. Ironically, the market´s fears have perpetuated the economic stagnation that negative rates sought to deter.
Negative overnight rates carry a number of severe unintended consequences that are starting to rear their heads. The large injection of credit has inflated the value of assets that are primarily owned by higher income groups, whilst most lower income household wages stagnate. Large real negative rates are also punishing low-income workers for trying to save. Both of these elements are rapidly amplifying wealth and income inequality. Additionally, the profitability of commercial banks in these countries are being squeezed dangerously close to insolvent levels. If negative rates deepen, this could result in a collapse of the monetary interchange system on which the global economy is built.
The downward pressure that negative bond yields have on the yield curves is also causing undesirable effects. The low returns on general investments mean that funds struggle to generate significant returns on their floats (the money invested in low risk assets to fully compensate their overall risk). This puts pressure on retirees and pensioners who count on annuity payments for their livelihoods, and reduces the support that Social Security Funds can provide to those in need. This environment discourages risk aversion, meaning that insurers, banks, and funds may increasingly engage in risky or even illegal activities.
Thus far, negative interest rates have not been necessary in the US due to stronger economic growth, market optimism, and better long-term investment opportunities. However, as other countries continue to depreciate their currencies by cutting rates, the US trade balance worsens, meaning the Fed will either have to accept slower economic growth or tend towards negative rates. After several cuts to their fund rates in 2019 and President Trump’s continued focus on reducing the trade deficit, we can already see where the Fed might be headed. The wider significance of a depreciated dollar is that other developed nations would see a fall in the injections they receive from US importers, which augments the economic stagnation that negative rates are already fighting.
It is unclear how policymakers will address the secular stagnation of the developed world in the face of this deep liquidity trap. Will we see even higher negative interest rates and yields? Or will Central Banks normalise rates despite the economic shock that would follow? The Swiss National Bank has introduced a “tiering” system where banks only experience negative overnight rates if they deposit sums of money above an exemption threshold. This mitigates some of the consequences of negative rates, but by no means is a viable long-term solution.