Recent News and Events
BoE and Fed will reject negative interest rate trap – 12 December 2019
Dr. Dan McLaughlin is a member of the Advisory Board of Santiago Investment Advisors. He was previously Chief Economist at Bank of Ireland and ABN AMRO Stockbrokers. This article was originally written for BlondeMoney, a financial and political consultancy founded by Helen Thomas (also a member of the SIA Advisory Board).
Ten years ago the Swedish central bank broke new monetary policy ground by cutting one of its policy rates into negative territory. Four other central banks followed – Switzerland, Denmark, Japan and the ECB – and in all cases longer term rates are also negative, albeit to varying maturities, while expectations on the return to positive rates also differ. Negative rates are different to just low rates and it is striking how opinion on their efficacy has changed recently, to the extent that other central banks are now openly ruling them out.
Conventional monetary policy is based on the idea that lowering rates will reduce the incentive to save while boosting credit growth and hence spending by consumers and the business sector. A rate cut into negative territory could therefore be seen as just another monetary easing, only more so.
It certainly has an impact on the exchange rate. In Switzerland, it is an explicit argument – the SNB sees negative rates as essential in dampening demand for the Swiss Franc, which is often the currency of choice in a ‘risk on’ environment. For Denmark too the FX rate is key as the Krone is linked to the euro via ERM II (yes, it actually exists although Denmark is the only current member).
The ECB decision to go negative, taken in 2014, is harder to fathom as the exchange rate is not a policy target and unlike, say the US, credit growth is largely driven by the banking system. The cost of funding for Eurozone banks fell as a result but a major problem began to emerge: banks were effectively faced with a zero lower bound in terms of retail deposit rates, so margins began to suffer. Some banks have cut deposit rates for larger corporate customers but all have baulked at a negative rate for retail deposits.
The problem was exacerbated by the scale of excess liquidity in the banking system, currently around €1,800bn; again this was a deliberate policy choice, as most of that was remunerated at the negative deposit rate. The ECB’s own surveys clearly showed the squeeze on the income of the banking system, although it took some time for the Governing Council to acknowledge this. A reluctance not extending to investors, as Eurozone banks on average trade at about 0.6 times book value, against around 1.4 in the US.
The ECB has belatedly taken some steps to alleviate part of the problem in that banks are now allowed to hold more reserves remunerated at the refi rate (currently zero) but this tiering adds a further degree of distortion.
There also remains a bigger issue relating to the signal that negative rates send to the wider population. Central banks can set short term rates but they cannot control whether households or firms avail of lower rates to borrow or indeed whether banks are willing to lend. The proverbial horse can be brought to the monetary stimulus water and all that…. But negative rates are seen as a crisis measure so it is not that surprising that the impact on actual credit growth has been underwhelming. Why risk building that new factory or buying that machinery if the outlook is as bleak as the central bank actions imply? It would also seem that households are actually saving more despite negative real deposit rates, partly as a precautionary motive and in part to maintain a desired retirement income.
So negative rates are in effect a trap, in that their existence may well act against an upturn in economic growth.
If so, the Eurozone outlook is pretty bleak as the market is not currently priced for a return to positive rates until 2025, which if it materialises would mean over a decade of negative rates in the euro area. It is unclear how the ECB gets out of this although we now know that there has been substantial disagreement on some of the measures taken including a deeper dive into negative rate territory. A big Euro depreciation appears one solution but the euro area runs a large BOP surplus which mitigates against a sustained Euro fall.
Mark Carney recently ruled out negative rates at the Bank of England, as have other MPC members, with the adverse effect on the banking system a key consideration. The Federal Reserve too are less than enthusiastic; the minutes of the October policy meeting noted that ‘all participants judged that negative interest rates currently did not appear to be an attractive monetary policy tool in the United States’. That might not go down too well in the White House but the Fed fears the ‘risks of introducing significant complexity or distortions to the financial system’. One should never say never but negative rates looks like one unconventional monetary tool thrown out of the box.
– By Dr. Dan McLaughlin
Standing on the Shoulders of Giants – 11 November 2019
Presentation by keynote speaker Anatole Kaletsky and an interview with Anatole and our Investment Advisory Board, Dan McLaughlin, Helen Thomas, Bernard McAlinden and Ronan O’Houlihan.
An absorbing evening with a fascinating talk from Anatole and a lively discussion afterwards. For those who were unable to make it and in case anyone wanted to listen for a second time we had the event videoed.
About Anatole Kaletsky
Anatole is founder and co-chairman of Hong Kong based economic and asset management firm Gavekal Ltd. A principal contributor to Gavekal Research and a columnist for Reuters and the International Herald Tribune, Anatole is a founding member and former chairman of the Institute for New Economic Thinking. His book Capitalism 4.0, on the post-crisis transformation of the global economy was nominated for the Samuel Johnson Prize. Anatole spent 30 years previously as an economic journalist and commentator for the Financial Times, The Economist and the London Times.