Negative interest rates on excess banking sector reserves is an unconventional monetary policy mechanism applied by developed world monetary authorities – aimed at encouraging lending by effectively charging commercial banks for holding excess reserves at the central bank.
Reserves held by the central bank on behalf of banks are considered among the most liquid assets in a financial system and can easily be called on to satisfy depositor claims. The fear of bank failure post the global financial crisis has resulted in an unprecedented build-up in commercial bank’s demand for excess reserves with central banks in the developed world – and herein lies the link to the advent of negative interest rate policies.
Figure 1: Reserves of US depository institutions with the Federal Reserve Bank
Source: Federal Reserve Economic Data, Futuregrowth Asset Management
In spite of developed world central banks flooding the banking system with liquidity in the immediate post-crisis period, a great portion of this money has flowed to excess reserves held by the central bank as opposed to filtering through to the broader economy, short-circuiting the ordinary workings of the deposit expansion process. This is for the simple reason that in an environment of financial and economic strain, liquidity is king. A banking system that cannot accommodate depositor’s claims to cash is doomed to failure.
What has brought it about?
Having gorged on lose credit standards prior to the sub-prime crisis, highly indebted households in the developed world have subsequently undertaken to lever-down by substituting debt repayments with savings and in so doing strengthening their balance sheet positions. The threat of household deleveraging to economic stability primarily stems from the resultant impact to GDP growth through suppressed credit extension and consumption expenditure.
Historically, deleveraging through belt-tightening has been a long and economically damaging process – and the defining characteristics of the current macro-environment suggest there’s more pain to come. Firstly, ageing populations globally are reducing labour force participation rates, making it harder to jump-start consumption expenditure, credit extension and economic growth rates as a consequence. Secondly, the prospects of counter-cyclical fiscal expenditure in much of the developed world have been curtailed by growth limiting fiscal austerity, as government’s endeavour to reign in unsustainable budget deficits of their own.
Monetary policy, through the use of unconventional monetary policy tools (quantitative easing and NIRP in particular), has therefore had to bear the inordinate burden of attempts to stave-off deflationary pressures and stimulate economic demand.
How low can monetary policy rates go?
Conventional wisdom held that nominal interest rates were bound to zero because investors could forego bank deposits and choose to hold physical currency instead, perceived to have a nominal return of zero. Physical currency is however subject to theft and physical destruction – among other risks – and is therefore not costless to hold. Hoarding of physical currency will only become a prospective alternative to bank deposits at a rate that negative interest rates outweighs the cost and inconvenience of holding/transacting in physical currency. A best guess to this cost could range between 1.2 – 2.0% per annum (Capital Economics, 2016). Put differently, negative interest rates could decrease to within a range of -1.2 – -2.0% before posing a significant risk to a flight to alternative (and more cost effective) stores of value.
What are the implications of negative rates on economic growth and financial stability?
Because the implicit target of real interest rates may be negative in an environment of heightened economic strain, some of the desired positive implications of negative nominal interest rates are thus quantitatively congruent to those of low, but non-negative, nominal rates. In addition to these intended policy implications, negative nominal rates may also be associated with the following undesired effects to economic growth and financial stability:
- Erosion of Bank profitability
Net interest income (NII) can be isolated as a proxy indicator for the negative consequences of negative interest rate policies on banking profitability considering its approximate 60% share of Eurozone banking income. Although banking sector interest expense bears benefit from negative nominal interest rates, the low interest rate environment so too compromises banking sector interest income. The net effect of this has been a 12% contraction in European banking sector net interest income since January 2010.
- Pressure on non-bank financial institutions
In a low interest rate environment, non-bank financial institutions such as pension funds and insurance companies may be hard-pressed to meet long-terms return targets required for the attainment of their long-term liability matching – a negative interest rate environment only exasperate this constraint.
- Excessive risk taking and asset price bubbles
The advent of negative interest rate policies has propelled the post financial crisis flurry of foreign interest in emerging market bonds, providing an anchor to yields and creating a conducive backdrop to burgeoning emerging market equity valuations - often flying in the face of weak domestic fundamentals in many of these emerging economies.
- Search for yield trades and associated asset price bubbles
The search for yield trade has spurred foreign buying of high-yielding local currency debt in the post financial crisis era. Blanket search for yield trades bear the significant risk of compressing idiosyncratic sovereign risk premia, and subsequently creating asset price bubbles in high yielding local currency debt markets.
Conclusions
Negative interest rate policies – as with Quantitative easing programs before and muted helicopter money drops – are monetary policy’s latest attempt at inducing credit lending and thus a sustained economic recovery.
Given that a disinflationary, growth starved global economy cannot be framed in a single context, so too is monetary policy unlikely to provide a silver bullet to the “reflation” cause. In a theoretical world, where policy mechanism function optimally, monetary policy becomes expansionary in periods of low inflation and economic growth suppression – spurring credit extension and economic activity. However, the weight on central banks becomes excessively burdensome when monetary policy rates remain at rock bottom in the developed world nearly a decade since the global financial crisis, yet meaningful economic growth and inflation still remain largely absent.
As a result of the interrelationship between interest rates, public debt management, price stability, the exchange rate regime and ultimately, macroeconomic growth – the resultant effect (and efficacy) of decisions taken by monetary and fiscal authorities inevitably depend on how policies of either of these ultimately affects that of the other.
Developed world monetary and fiscal policy levers pulling in opposite directions bears the risk of reducing the efficacy of each individually in achieving their stated objectives. Moreover, a weak fiscal policy stance has overburdened developed world monetary policy – bringing into question the efficacy and long-term sustainability of the current set of monetary policy tools.
