For centuries, the bedrock assumption of finance was that borrowers paid interest and lenders and investors received interest, and that nominal interest rates would always be positive. That assumption has been turned upside down in recent years as lenders are now paying interest to borrowers; this prevails mostly in the commercial banking industry on banks’ deposits, called reserves, at the central bank. These reserves can either be required to back customer deposits at the bank or excess, those not needed to back customer deposits. Central banks are now charging commercial banks in 23 countries for their reserves on deposit or on their excess reserves.
Ever since the Great Recession (2008-2009), central banks have had to do the heavy lifting getting economic growth back on track and reducing deflationary pressures. First came the near-zero interest rate policies (NZIRPs), then quantitative easing (QE) and now the negative interest rate policies (NIRPs). The NZIRPs were implemented to boost aggregate demand by consumers and corporate investment by lowering borrowing costs. Another intent was to create a wealth effect by increasing bond, stock and housing prices, making consumers less risk-averse and more willing to spend or invest. QE programs involved massive amounts of bond purchases by central banks with the intent of lowering long-term interest rates on mortgages, auto loans and corporate bonds. The NIRPs work on the supply side by making loans more readily available to borrowers. Central banks impose an interest rate on bank reserves to motivate banks to lend excess reserves to borrowers to help invigorate lethargic economic growth. And there are unprecedented amounts of excess reserves on deposit at central banks.
The central bank of Sweden was the first to have an NIRP in 2009 but dropped it and raised interest rates as the economy improved. The ECB started its NIRP in June 2014 at -0.3%, joining Sweden (-0.5%), Denmark (-0.65%) and Switzerland (-0.75%). In January Japan joined the 22 European countries, 19 in the Eurozone, by implementing an NIRP with a -0.1% charge on some bank reserves as well as maintaining a massive QE program. In March, the ECB made a further cut in its negative rate to -0.4% and increased its QE program to €80b monthly, including the purchase of investment-grade corporate bonds denominated in euros. They also cut the short-term borrowing rate by banks to zero. Interestingly, the ECB imposed a negative rate on itself by offering to pay banks 0.4% to borrow money on a longer-term basis up to 4 years, as long as the banks lend the borrowed money.
These NIRPs have carried over to the bond markets as $7t of bonds, mostly government, have negative yields. This represents 25% of all government bonds outstanding in developed countries. In Japan and Switzerland, government bond yields are negative out to 10 years maturity, 8 years in Germany and the Netherlands, 7 years in Belgium and France, 5 years in Sweden and Denmark, 4 years in Italy and 2 years in Spain. A year ago there was less than $1t of government bonds with negative yields. There are also billions of dollars of corporate bonds with negative yields mostly in Europe and Japan. Some corporate bonds have been issued with a negative yield, Nestlé in Switzerland and more recently a bank in Germany. Today two-thirds of the $26t of government and corporate bonds in the Bank of America Merrill Lynch bond index have yields that are less than 1% or negative.
What are the potential problems with NIRPs? There are a multitude. Low and negative interest rates are challenging for banks that borrow (take deposits) short term and lend or invest long term. Thus far banks have been reluctant to impose negative rates on deposits but have had to lower rates on loans, sometimes negative, to stay competitive. Their net interest margin is being squeezed. Life insurance companies are also impacted as they have guaranteed rates on annuities and other insurance products. Money market funds have struggled with NZIRPs and NIRPs just exacerbated their margins or lack thereof: eleven of the largest money market funds in Japan have turned away new deposits and may return existing funds to depositors. NIRPs present problems to defined benefit pension plans that have assumed returns on investments well in excess of bond yields. More NIRPs may have dire consequences for many financial institutions. And NIRPs are a repression on savers who are receiving near-zero interest rates and perhaps negative in the future.
In addition to financial institutions and savers, NIRPs potentially increase risks to financial system stability by creating bubbles in financial assets like stocks and bonds and real assets like housing. It may also create problems for investors chasing yields in riskier assets and longer maturity assets. Many believe the primary objective of NIRPs is to weaken currencies and make a country’s exports more competitive. This is a zero-sum game if all countries try to devalue and risks the potential of currency wars and trade protectionism. Finally, NIRPs may signal that prior monetary policies such as NZIRPs and QE have failed and people will lose confidence in central banks and then they have a credibility problem.
One unintentional consequence of NIRPs has been cash hoarding and a surge in safe sales in Europe and especially Japan. The cash hoarders are ordinary citizens responding rationally to NIRPs which work only if savers spend or invest their money. Money is unproductive if stuffed under a mattress or in safes and safe deposit boxes. Cash hoarders prefer large denominations as do those carrying out illicit activities such as drug trafficking, money laundering, tax evasion, corruption and terrorist activities. The high denomination notes like the $100 bill, the €500 note, the SFR1000 note and the ¥10,000 note make up the largest portion of the respective paper currencies.
Demand for these has accelerated in Europe and Japan; circulation of the SFR1000 notes ($1010) grew 17% in 2015 after Switzerland imposed a NIRP in January 2015.
Cash hoarding is an impediment to NIRPs and because of that some economists want to retire high-denomination notes and others to eliminate all paper currency and go digital. Theoretically negative interest rates can go lower but are constrained by cash hoarding, shadow banks and other factors.
NZIRPs, QE and NIRPs all had the same objective of stimulating stagnant economies. The question is have they worked? Japan has had an NZIRP and QE for some time but their NIRP is just two months old. The initial reaction to it was not as expected. The yen did not weaken, but strengthened relative to the dollar by 8%, savings increased and borrowing declined as citizens began to hoard cash. An NIRP has not helped Europe which is still experiencing anemic growth and deflationary pressures. There have not been a lot of positives so far with the NIRPs, except perhaps for lower borrowing costs, especially for governments, but that also could have unintentional consequences. The lack of robust economic growth in the countries that have implemented these policies may be due to other economic headwinds, and these economies may have been in worse shape if the policies had not been adopted.
Christine Lagarde, managing director of the International Monetary Fund, states “if we had not had those negative rates, we would be in a much worse place today with lower growth and lower inflation.” Former Fed Chairman Ben Bernanke stated in his blog that negative interest rates “appear to have both modest benefits and manageable costs” and that “market anxiety over below-zero borrowing costs seems to me to be overdone.”
Even though the Fed raised short-term rates in December, some, including Congress, are questioning whether the U.S. could experience negative interest rates in the future. Janet Yellen, Fed chairperson, stated in congressional testimony in February that negative rates were discussed in 2010 but not implemented at that time. She also stated that she was not aware of anything that would prevent the Fed from implementing a NIRP but it would need further investigation of legal hurdles. The Fed already includes a negative interest scenario in bank stress tests and short-term U.S. Treasury bills have occasionally had negative yields.
If these monetary policies lose their efficacy or potency, what might be the last salvo of monetary policy? One possibility is what the late Milton Friedman referred to as a “helicopter dumping policy” (HDP). This would entail the central banks directly financing government spending or tax cuts, or directly sending checks to tax payers. This would be a more dramatic monetary policy than the three prior ones and would certainly be the “big bazooka” in stimulative monetary policy. It is hard to imagine HDPs ever being implemented, but a decade ago the same could have been said about NZIRPs, QE or NIRPs.