Are Negative Interest Rates Ineffective?

This piece was originally produced for and posted by MNI News.


The European Central Bank initially received praise for its decision to push the deposit rate below zero as part of its truly unconventional monetary policy. The euro plunged, equities recovered, and euro area manufacturing outperformed its global peers.

Holders of long-term benchmark bonds have been handsomely rewarded by the ECB’s monetary policy experiment as 10-year yields in Germany have resumed their violent decline. And investors expect more, judged by the decline in short-term yields indicating a further interest-rate cut in March of at least 0.2 percentage point.

But equity investors in the banking sector have been voting with their feet. This is partly due to fears over new rules allowing regulators to bail in creditors and equity holders. But it is also because of angst that already- beleaguered Eurozone financial institutions will suffer further slings and arrows from disappearing net interest-rate margins.

Adding insult to injury, currency markets have also challenged central banks’ use of negative interest rates. Global growth fears have led to the unwinding of euro- and yen-funded carry trades, pushing up the value of the two currencies. The Bank of Japan’s attempt to curb investor interest in its currency by lowering its deposit rate below zero has so far been no match for the upward pressure on the yen.

Risk sentiment eventually will recover, and so will traders’ inclination to use the euro and yen as funding currencies. But it is difficult to deny that one of the cornerstones of post-2008 monetary policy tools has suffered a severe blow. A large central bank like the ECB can enjoy a first-mover advantage by being the first to push interest rates below zero. But as other major central banks follow, diminishing returns set in, and the disadvantages could begin to outweigh the advantages.

The potential downsides from negative interest rates are hotly contested, but we can point to at least two clear examples in the euro area.

Banks’ return on equity and net margins have recovered somewhat following the sovereign debt crisis in 2012. But downside risks are looming, based on the persistent decline in interest rates. Based on the historical relationship between return on equity and long-term bond yields, investors currently face negative returns on Eurozone bank equities.

The money market industry is another victim of low interest rates. Assets under management in money market funds have been resilient despite low interest rates. This is likely a result of QE. Surging ECB demand for government securities means that the tax from negative interest rates has been lower in money market funds than in government bonds.

But these funds’ business model doesn’t make sense at negative interest rates. We estimate that the most of the eligible assets for the Eurozone’s money market funds trade with yields below zero. Customers will be willing to pay for access to liquidity, but only to an extent, and money market funds won’t survive this interest rate regime for ever.

A more fundamental critique levied at negative interest is that the policy leads to behavior opposite of what central banks want. The portfolio rebalancing theory suggests that lowering benchmark yield via quantitative easing (QE) and zero interest rate policy (ZIRP) pushes investors to move funds further out the risk spectrum. The idea is to encourage money managers and wealth holders to lend their capital to riskier but also more productive projects. We have certainly seen a tremendous search for yield in many markets and asset classes, but deeply negative interest rates could also have perverse effects.

Plunging bond yields erode returns on the safe and relatively liquid part of investors’ portfolios. They also expose investors to volatility in their core fixed- income holdings that they haven’t been used to, when yields suddenly spike higher. This could curb the desire to seek higher returns in equity and credit markets, the opposite of what central banks sought to achieve with unconventional policies.

Finally, negative interest rates send the signal that the economy is in dire need of emergency support. This could push consumer and business confidence lower, because it signals that growth will remain low and weak for an extended period.

The markets’ questioning of negative interest-rate policies suggests a tactically savvy ECB should rethink its strategy. Specifically, the central bank could choose to keep its deposit rate unchanged next month, and compensate with a larger-than-expected extension and increase in QE.

But we doubt it will choose this route. De-emphasizing negative interest rates as a policy tool could send the euro higher, further dampening inflation expectations. Negative interest rates are an imperfect tool, but our bet is that key central banks will continue to deploy them as long global disinflationary headwinds remain.