The Broad View
It can feel like negative interest rates sprang from the bizarro world. After all, negative rates involve lenders paying borrowers and depositors paying banks — precisely the opposite of how the financial system is supposed to operate. Even the term itself seems like an oxymoron. Aren’t interest rates by definition always positive?
Such is the improbable phenomenon that has become reality across much of Europe and Japan. The rationale behind negative rates is simple enough: Conventional stimulus measures have had mixed results in boosting low-wattage growth, so major economies are turning to a strategy that was once deemed more theoretical than practical. The basic idea is to nudge banks to increase lending, while prodding businesses and consumers to spend rather than stockpile their money. The European Central Bank implemented negative rates in 2014, the Bank of Japan in 2016.
There are conflicting opinions about whether the policies have worked, and a deeper debate about the wisdom of relying on them long-term. Nevertheless, they’re likely to remain part of the financial terrain in the foreseeable future, with one big exception: the U.S. Barring a significant recession, it’s unlikely that the Federal Reserve would go this route. U.S. consumer spending is vibrant, the job market is healthy and GDP growth is steady. And longer term, the U.S. economy has other buffers against negative rates: flexible labor markets, a dynamic economy and an array of innovative companies. Policymakers would almost certainly look to other measures if the economy short-circuited.
“Negative rates would be pretty low on their list,” says John Queen, a fixed income portfolio manager at Capital Group Private Client Services. “They would try a number of other things first.”
Still, the counterintuitive nature of negative rates has prompted lots of curiosity, says Capital Group economist Jared Franz. “I have a lot of relatives, and they’ve all asked me about it,” he says.
Here’s a quick look at this phenomenon and what it means for financial markets and investors.
For decades, central banks followed a basic script whenever their economies ran aground: slash interest rates to discourage saving and spur borrowing. Negative rates follow the same principle — with a twist. Keep in mind that banks store their excess reserves at central banks in much the same way that individuals deposit money at commercial banks. Normally, commercial banks earn interest on their deposits. With negative rates, however, central banks are effectively charging commercial banks to stash their money. To avoid those fees, banks must use that money to pump out loans. That’s also why negative rates aren’t likely to come to consumer loans — with banks pressured to replace lost income, they can’t afford to offer loans that lose money.
For the most part, commercial banks haven’t passed on their added costs to everyday customers, partly because of concern that depositors might flee to competitors or stuff cash under their proverbial mattresses. However, many banks have turned to fees to pad their bottom lines, and this has had the same practical effect — consumers end up paying to store their money.
Negative rates also have emerged in the world of government debt. In a scenario that may seem even more far-fetched, investors are paying more for certain bonds than the securities are worth. In other words, investors are shelling out more than the total amount they’ll receive at maturity and from dividends collected along the way.
Why would a depositor or bond investor tolerate negative rates? Sometimes because they have little choice. For example, some European banks have applied negative rates to institutional customers and a small number of large retail accounts. Depositors have grudgingly accepted small costs to avoid the headaches and attendant risks of holding the money themselves.
Bond investors face other pressures. Insurers, for instance, are required to hold bonds of a minimum creditworthiness; because many negative-yielding securities are issued by countries with sound credit, these financial institutions have few alternatives. And for hardier investors, there can be an odd appeal to such debt: If yields tumble further, the investors can profit as older bonds gain in value.
Whether negative interest rates have achieved policy goals is debatable. In the nearly six years since policymakers have taken this route, the eurozone has managed to skirt a recession even as Chinese economic weakness has eaten into Germany’s powerful industrial base. And investment spending has remained surprisingly robust across the Continent. On the other hand, average annual eurozone growth has been below 2%. Japan has been similarly underwhelming.
Regardless of their other effects, negative rates always squeeze bank profitability. If they fall too low, they could cause banks to begin offering fewer loans or to pursue riskier strategies that offer higher returns.
“If they weaken bank profitability, that can cause banks to pull back and extend fewer loans,” says Capital Group economist Anne Vandenabeele. “If they go down enough, they can become an overall negative for the economy.”
More broadly, there are concerns that negative rates distort the natural flow of capital. Ultra-low borrowing costs, for example, could fuel “zombie” companies and asset bubbles if consumers and businesses gorge too heavily on cheap debt.
“The benefit is these policies get the economy out of stagnation,” Franz says. “The cost is they create bubbles that have to be cleaned up afterward and potentially delay structural reforms.”
And all kinds of strange behavior can crop up. Sweden’s tax collectors learned that firsthand when people chose to overpay tax bills rather than keep money in negative rate accounts. This made the government an unwilling bank of sorts — perhaps marking the first time a tax agency wanted less compliance.
But that’s likely to be a worry of the past for Sweden. After being the first major central bank to charge commercial banks to hold their deposits, in 2009, Sweden recently became the first to scrap negative rates. With inflation edging up toward its 2% goal, the country decided to avoid the larger risks.
The above article originally appeared in the Winter 2020 issue of Quarterly Insights magazine.