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12 Aug 2020

Exploring the pros and cons of negative interest rates

By Matt King, Catherine Mann & Mahjabeen Zaman Are central bankers caught in their own thought bubble?

In the aftermath of the global financial crisis (GFC) governments and central banks began picking up the pieces, after having thrown everything at their disposal into staving off global insolvency. It raised the question: What will we do if there is another major economic catastrophe?

We can now answer that question, as we are in the midst of another economic calamity, caused by a health crisis, and governments and central banks are once again throwing everything at their disposal into economic stimulus.

The benefit this time is that the global banking system is much stronger, as on the back of lessons learned from the GFC, governments and regulators tightened controls to ensure banks could withstand a dramatic drop in economic activity. So far, we can say they did a good job.

The downside is that interest rates stayed low, and continued to head lower after the GFC to drive business activity, so there is less room for monetary policy to play a major role going forward in driving new economic growth.

But that does not mean there is no ammunition left in monetary policy, and it raises two questions: Will we end up with negative interest rates as we continue to fight the impacts of COVID-19? And where can we look for lessons about what it may mean?

Look to the recent past

In an effort to stimulate their economies post the GFC, five major central banks have experimented with negative interest rates, including the European Central Bank and Bank of Japan.

In practice this means they’ve lowered their policy rates to a point at or below zero, meaning banks that want to park excess cash at the central bank have to pay a fee instead of receiving interest. The theory is that if it’s unattractive for banks to park their money, they’ll lend it instead. It’s the same for same for consumers. If they’re faced with paying a fee to hold their money in a bank, they hopefully will take the money and spend it in the economy.

An infographic showing the impact of negative rates on various financial categories


Impact on households

In theory negative rates should increase the desire to borrow, and reduce the impulse to save. But in reality, household savings rates, while varying greatly from country to country, have increased overall. Only in Switzerland have savings rates fallen — and then from an extremely high level.

Indeed, the evolution of savings rates in the euro area suggests there may even be something about the extreme nature of negative rates and yields which creates a break in prior relationships.

When real yields were falling but still positive, savings rates fell in tandem — in line with theory. But once real yields went negative, households seem to have rebelled by saving more. More striking still is that surveys show people recognised it was not a “good time to save”.

This trend was also observed during the 2013-2019 economic recovery, indicating people are more concerned about their perception of the economic climate then policies designed to change their behaviour, like negative interest rates.

Impact on corporates

Low or negative rates are supposed to stimulate corporates to borrow more, ideally for the purpose of investment and hiring. While lower rates have unquestionably helped to bring down the cost of borrowing, whether this has led to larger amounts of borrowing and investment in practice is a little less obvious.

The rates at which companies can borrow have indisputably fallen in recent years, and negative rates and other central bank policies have almost certainly helped to encourage this.

It is also true that investment rates have risen from post-crisis lows, and at first sight it seems reasonable that a lower cost of borrowing may have helped to encourage this. The European Central Bank (ECB), for example, cites evidence that corporates with a large level of cash at negative rates have invested slightly more than corporates with lower cash levels.

However, the drivers of corporates’ desire to borrow and invest remain complicated, and in many respects seem to be driven by factors other than the cost of borrowing.

One explanation could be that corporates need to look at both the equity and debt side of the balance sheet, and maintain a weighted average cost of capital.

Because equity is currently more expensive to bring onto a balance sheet, the trade-off may be lower borrowings than the environment would seem to warrant.

A broader question on corporate borrowing is ‘will those funds generate jobs and investment?’

Both the GFC and COVID-19 have forced companies to focus on processes, and being more effective with what they have.

While this may lead to investment in technology and digital solutions, it does not have to equate to an expanded footprint and more feet on the ground.

An option on the table is for central banks to directly buy equities, as the Bank of Japan is doing. However, years of low rates in Japan have done little to spur corporate demand to borrow. Real investment for expansion may require boardrooms to feel comfortable that economic recovery is long term and sustainable.

Do negative rates drive inflation?

Throughout modern history, central banks have relied on rate cuts to stimulate the economy in the face of downturns, staving off recession and getting the economy back on track.

But the problem of using rate cuts in the current environment to achieve inflation objectives is particularly worrisome, given the growing evidence of a persistent inability to prevent inflation falling beneath central bank targets. The US Federal Reserve, ECB, and BoJ’s forecasts for inflation have in recent years all proved a triumph of optimism over reality.

When evidence of persistent deflation risks first surfaced in Japan in the 1990s, some central banks argued the BoJ had been too slow to act, and insufficiently aggressive. But the similarity of the inflation experience in other countries following the GFC, and now the coronavirus crisis this year – and notwithstanding over $US17 trillion in quantitative easing (QE), suggests new ideas are needed.

What do we do now?

This brings us to the broader question. Are ever higher asset prices and more credit needed right now, as central banks maintain, in order to combat a potentially ‘deflationary mindset’?  Or at some point does the expansion of asset price bubbles, and the inevitable turbulence when they burst, simply fuel inequality and populism, and add to the potential for economic disruption.

There is a role for monetary policy, and both negative rates and QE have an important part to play in a central banks’ arsenal when it comes to combating panic in markets, credit contraction, and acute deflationary pressures in both asset prices and the real economy. But that assumes they are applied when financial conditions are already tight — not, as now, when they are neutral to easy.

Put differently, the case for rate cuts and QE felt very strong in March of 2020, when rates markets were in turmoil, real yields were spiking, and risk assets were at risk of a sell-off.

But what, realistically, can such policies hope to achieve today, with U.S. dollar investment grade bond yields having just reached new all-time lows, those in other currencies within a whisker of them, and some equity indices reaching new highs?

Rather than unconventional monetary policy causing the financial sector to spur on the real economy as intended, there is an ever broader consensus that it is simply becoming detached from it.

The problem is not the monetary policy instruments themselves, but rather the manner of their application. Doubling down on the policies when a real-world shock like the coronavirus hits exposes the impotence of monetary policy alone.


Like many a great idea, it is the elevation of negative interest rates beyond being a temporary backstop into being a mainstream permanent instrument of policy which risks seeing the side effects cumulate to the point where they are counterproductive.

Our conclusion is generally a cautionary one — albeit not just about negative rates. While there is some evidence that negative rates may be less potent than quantitative easing (QE), unconventional monetary policies as a whole do seem to have supported credit growth, and have definitely been pushing up asset prices and suppressing risk premia. But these financial market effects have not transmitted to inflation, nor in general to the pace of real economic activity — at least not in a magnitude commensurate with the monetary policy effort.

Matt is Citi's Global Markets Strategist

Catherine is Citi's Global Chief Economist

Mahjabeen is a Senior Investment Specialist for Citi Australia

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