Demystifying negative interest rate policy

Abdullah A Dewan    | Published: September 09, 2019 20:26:11

US Federal Reserve Chairman Jerome Powell speaks during the "The Economic Outlook and Monetary Policy" panel discussion hosted by the Swiss Institute of International Studies at the University of Zurich in Zurich, Switzerland September 06, 2019.                  —Photo: Reuters

When the US Federal Reserve  Chairman talks, central bankers and financial market watchers around the world listen  -- be he/she the former chair or the current chair. This week they both spoke within a span of two days from two different continents.

"You're seeing it [negative interest] pretty much throughout the world. It's only a matter of time before it's more in the United States", so said the former Fed Chair (https://www.cnbc.com/alan-greenspan) Alan Greenspan on CNBC's "Squawk on the Street" show on Wednesday, September 04, adding "investors should watch the 30-year Treasury yield".

Speaking during a forum in Zurich, Switzerland on September 06, the current Chairman of the Fed Jerome Powell said, "We are not forecasting or expecting a recession. The most likely outlook is still moderate growth, strong labour market and inflation continuing to move back up."

Greenspan's looming negative interest rate contention may seem like an omen about an impending recession in the US while Powell's lukewarm optimistic insight about the U.S. economy is telling us - recession is not yet in sight. Obviously, Greenspan's pessimism is triggered by stagnation of global economies, which often become contagious to the U.S. economy.

As reported on the CNBC's talk show, there are currently more than $16 trillion in negative-yielding debt instruments around the world as central bankers are resorting to nontraditional policy tools to avert economic slowdown. For example, the 10-year sovereign bonds in Belgium, Germany, France and Japan - among others - are trading with a negative yield while yields on the US Treasury are still well above zero. The rates on the 30-year U.S. Treasury bond are hovering around 2.0 per cent.

A negative interest rate policy (NIRP) is an avant-garde tool that was first surfaced in the1970s. For example, in the early 70s inflation was accelerating in some parts of the world. Investors from those countries were fleeing the inflation havoc to shelter their money in Swiss franc causing a huge appreciation of the Franc and a drastic fall in Swiss exports. To counter this quandary, the Swiss government resorted to a de facto NIRP regime. In recent years, Sweden (2009) and Denmark (2010) adopted NIRP to stalk "hot money flows" into their economies. More recently, in 2014, European Central Bank (ECB) instituted a NIRP regime directed only to bank deposits intended to thwart the Eurozone from falling into a deflationary spiral. The less radical policy that was used following the 2008 Great Recession by the Fed and central banks around the word was zero interest rate policy (ZIRP).

The NIRP is pursued by setting the nominal interest rate target below zero. Negative interest rate means depositors are required to pay fees on a regular basis to park their money in banks instead of receiving interest on them. Commercial banks are charged interest as a penalty to hold their excess reserves in their central bank accounts instead of lending them. In the bond market, negative yield happens when the coupon rates (interest rates on bond) are set at low or below zero. When these bonds are auctioned above face value yields dip below zero.

The NIRP was envisioned to boost spending by individuals and businesses rather than hold money in the safety of banks and pay fees. For example, when an economy experiences deflation, individuals and businesses pile up money instead of spending and investing. This adversely depresses the aggregate demand, deflating prices further while causing drastic slowdown or even halting production and increasing widespread unemployment. To lift the economy out of stagnation, traditional policy of lowering interest becomes ineffective if the interest rate is already at or near zero. In such a predicament, NIRP has been deemed as a last-ditch option to spur spending, investing and reflation. How does this work?

The theoretical rationale is that an interest rate below zero reduces the costs of borrowing by households and businesses, thereby increasing the demand for loans. Households will borrow to spend on consumer durables and housing and business will borrow to spend on capital goods and therefore aggregate demand will be rejuvenated.

A real-world example of NIRP could be targeting the benchmark interest rate, say at negative 0.25 per cent (-0.25%). That will require depositors paying banks a monthly fee of $5 on a deposit of $2000 while receiving no interest. The upshot is that the depositors lose $60 annually on the initial deposit and additionally, suffer some losses of some purchasing power of their money unless the inflation rate is zero.

While the U.S. economy is still having a demurred happy ride with 2.2 per cent growth, under 2.0 per cent inflation rate and near full employment at 3.7 per cent, the European and the leading Asian economies are weakening with bond yields progressively tiptoeing into negative territory. Negative yields beyond the U.S. border is turning the U.S. bond market more attractive with positive yield and is driving more buying from investors in the U.S. and beyond. And with more buying of longer-term bonds, yields are falling, and prices are rising.

NIRP is pursued as an act of desperation - signaling that traditional policy options such as open market operation (OMO- purchase, a.k.a. repo) has tended to be benign. The policy penalises banks (by cutting profits) that hoard cash instead of extending loans. During and after the 2008 Great Recession, Central Banks pursued a nontraditional quantitative easing (QE) policy which involved targeting a desired money stock (extremely expansionary policy) since interest rate is already at or near zero.

No matter where and how one looks in the global economy right now, major economies are having an uneasy time, and it is quite likely that interest rates in the US could revert to ZIRP or the extreme NIRP regimes as former Fed Chairman Greenspan has alluded to. When the global economy plunged into the great financial crisis in 2007, central banks and governments went to experimental extremes with QE policy. The Fed pulled the trigger with ZIRP and blew up its balance sheet to bail out the Western world and avert another Great Depression of the likes of 1930s. Prior to the financial crisis the interest rates were around 5. per cent. They're currently stuck at 2.25 per cent. How bad would things be at 5.0 per cent? The Fed could easily keep cutting interest rate in succession to reach to ZIRP. With the current interest rate at 2.25 per cent, not too many cuts are available. Central banks around the world are nervous and do not want a repeat of 2008-2009, which would destroy any confidence that remains in the financial system. Let us see what the IMF which along with the Fed monitors the stance of the global economy.

"Many central banks reduced policy interest rates to zero during the global financial crisis to boost growth. Ten years later, interest rates remain low in most countries. While the global economy has been recovering, future downturns are inevitable. Severe recessions have historically required 3-6 percentage points cut in policy rates. If another crisis happens, few countries would have that kind of room for monetary policy to respond to. To get around this problem, a recent IMF staff study shows how central banks can set up a system that would make deeply negative interest rates a feasible option.

The primary reason why the global financial system has fallen into the negative interest trap is due to untenable debt. What's the recourse then? There are four ways to remedy this debt debacle: default, inflation, economic growth, and currency devaluation. Debt defaulting threatens  financial system insolvency and collapse, inflating the economy using post-1990s policy seems weak, global economic growth is stagnant and weakening, and currency devaluation is an unwelcome option due to the floating exchange rate system adopted in 1973 that ended the Bretton Woods framework after President Nixon suspended the dollar's convertibility into gold.

ZIRP and NIRP as monetary policy tools are appropriate for economies with active bonds market where central banks enjoy a high degree of independence in policy design and implementation. For developing economies like Bangladesh, these policy options may seem academic at this time, but it is never too early to crawl through the learning curve if such policies were to become the art of conducting monetary policy in desperate times in the future.

However ridiculous or exotic the NIRP regime rings, the idea is to boost lending, increase inflation to jolt production and business profits, and thus reinvigorate the economy after other options ran out of vitality. Yes, it is prima facie an eccentric strategy that has already distorted some financial markets and aroused complaints and clamours that the policy is backfiring. In fine, it is safe to say that NIRP will either mark the debut of a new dawn for central bankers or dismayingly expose the limits of their policy innovations.

Dr Abdullah A Dewan, formerly a physicist and a nuclear engineer at BAEC, is professor of Economics at Eastern Michigan University, USA.



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