A negative view of negative rates

My views on the disadvantages of low interest rates have been set out on this blog over recent years and increasingly there are indications that this view is moving into the mainstream. Indeed, across large parts of Europe the debate is not about low rates but rather negative rates. The theory of negative rates is simple enough: Banks are penalised for holding excess liquidity on deposit at the central bank and therefore have an incentive to lend it out. Whilst this policy may work for a limited period of time, it is now more than five years since the ECB lowered the deposit rate into negative territory. 

Today’s move to reduce it further to -0.5% may well be counterproductive although the ECB has finally recognised that forcing rates lower will simply impact on the bottom line of the banking sector and have introduced a system of tiering to provide some form of relief. Nonetheless, the negative interest rate policy is not having the desired effect and rather than continue with more of the same, it is time to reconsider our monetary options.

It is ironic that on the same day the ECB announced changes to monetary policy, the Swiss Bankers Association issued a strong statement decrying the SNB’s negative interest rate policy, arguing that “the societal, structural and long-term damages will become even greater the longer we find ourselves in this ‘lower forever’ environment.” SBA Chairman Herbert Scheidt argued that “negative interest rates are causing massive structural damage to the Swiss economy and disadvantages for the country’s citizens. They result in bubbles and damage the competitiveness of the Swiss economy long term because they keep unprofitable companies alive artificially. Negative interest rates also put the pensions of Swiss citizens at risk. A further lowering of interest rates would further exacerbate this issue. The longer negative interest rates remain in place and the greater the structural damage for Switzerland, the more urgent it becomes to ask from which point onwards countermeasures must be taken against negative interest rates.”

There are a lot of strong arguments there which deserve to be taken seriously. The idea that zombie companies are kept alive artificially is of short-term benefit to those who would otherwise be put out of work, but in the longer-term it hampers the efficient allocation of resources throughout the economy to areas where returns are higher. I have long argued that pension fund returns will be dampened by excessively low interest rates and a report this week highlighted that annuity rates in the UK have fallen to historic lows. Every £10,000 in the pot yields just £410 – down 12.3% from the start of the year – compared to between £900 and £1100 in the 1990s. In effect, buying an annuity to generate a guaranteed lifetime income will, in the words of pension expert Ros Altmann, “mean poorer pensioners for the rest of their lives.”

The impact of loose monetary policy on boosting financial markets to levels which look way out of line with fundamentals has been well documented. Although conventional P/E measures suggest that equities look extremely expensive in a historical context, the fact that the dividend yield on stocks is significantly higher than bond yields for the first time in almost 60 years means that investors are unlikely to dump equities any time soon (chart). By raising the net present value of housing services, low interest rates have also boosted house prices above fundamentally justified levels (a subject to which I will return). 

 

There is, of course, a risk that if markets have been inflated so much by low interest rates, any attempt to raise them will cause the bubble to deflate quickly. Central banks concerned with maintaining the stability of the financial system will be keen to avoid such an outcome. On this reading of events, the lower rates go and the longer they are maintained, the more difficult it becomes to raise them. The US may provide a counterfactual where markets continued to perform strongly despite the fact that the Fed was raising rates, but this was partially owed to the Trump Administration’s corporate tax cuts so the jury is still out.

We should not overlook the fact that central banks can only impact on the supply of credit and its price, but not demand, and we are increasingly at the point where reducing interest rates is akin to pushing on a string (to use the phrase attributed to Keynes). But I had an interesting discussion with a colleague who suggested there is nothing special about negative rates per se – the main problem is that positive rates have been baked into so much contract law that we struggle to deal with negative rates. He described a case of two identical derivative contracts where one receives a floating rate payment over the period of an EONIA contract whereas the other defines a fixed payment calculated on the reference (EONIA) rate. Both are essentially the same instrument in a world where interest rates are above zero but they are treated differently in a negative rate world because interest payments “cannot be negative” whereas the fixed payment can.

In a similar vein, the Finnish financial regulator is currently trying to assess whether it is legal for banks to pass on negative rates to retail depositors. Different countries have taken a different approach to this problem, with some refusing to levy the charge on retail customers. But this raises a question of whether depositors might simply withdraw their funds from one country and place them in another euro zone country where depositors are protected. To the extent that the period of negative rates has lasted longer than anyone initially anticipated, banks’ business models are going to have to change. Last month Jyske Bank in Denmark announced it would issue 10-year mortgages at a rate of -0.5%, although the bank will not lose money on the product since fees and other charges will be sufficiently high to ensure a profit. This may well be a template for the rest of Europe where fees and charges are likely to rise as banks struggle to make a profit in a world of negative rates.

It appears that ECB Council members were not unanimously in favour of the measures adopted today, with the central bank governors of France, Germany and the Netherlands reportedly opposed to a resumption of bond purchasing. Their views on negative rates are not known but this is an indication that northern European central bankers believe we are very near the limits of what an expansionary monetary policy can achieve. Mario Draghi may thus have delivered a poison pill to Christine Lagarde, who takes over as ECB President at the start of November. With Draghi having maxed out the credit card during his tenure, it will fall to Lagarde to deal with the consequences.