Negative interest rates: coming to a bank near you?
28 July 2016 by Gerard Lyons
Negative interest rates: are they coming to a bank near you? To understand this, it is necessary to look at this from an economy wide perspective.
It is a legacy of the 2008 financial crisis and a feature of many "advanced economies” across Europe and North America and including Japan who have relied extensively upon monetary policy to help boost their economies.
Since 2008, in the west, economic growth has been modest, and inflation low. As a result, monetary policy has been the economic shock absorber. Interest rates have been cut, quantitative easing has occurred with central banks printing money, buying assets and injecting liquidity. The balance sheets of central banks have ballooned, meaning they now own more assets, particularly government debt. Interest rates have been low across the whole yield curve, making it cheaper for firms to raise finance and for people to borrow for mortgages.
In March 2009 the Bank of England cut policy interest rates to only 0.5%. Now it seems likely that UK rates will be cut further, possibly to zero or even lower.
ZIRP is the acronym used to refer to zero interest rates. It has been a feature of Japan for much of the last two decades. Now there is also NIRP, which is negative interest rate policy. When acronyms are the best way to capture what is happening to monetary policy, it may be time for savers and investors to strap in for the journey ahead.
It is easy to overlook that Denmark was the first European country to opt for negative interest rates, as long ago as 2012! That was in response to the euro crisis and to deter speculative inflows into the Danish krone. Now NIRP is becoming more common.
In fact this year there has been a significant shift in global policy combining two elements.
One has been additional easing in monetary policy. And the most attractive safe havens from a global perspective include some countries with negative interest rates: namely Switzerland and Japan.
If one looked at the hundred largest economies in the world, during 2016, one third have cut interest rates, 53 have left rates unchanged and just 14 have hiked. Bizarrely Denmark is included in those 14 as it raised rates at the start of the year although rates there are still negative. The countries hiking rates include Brazil, Mexico, Nigeria and Egypt and collectively account for a small fraction of the world economy. In contrast those cutting rates account for around two fifths of the size of the global economy.
The US, however, has left rates on hold so far this year but now looks set to hike again. This highlights how it is necessary to look at domestic factors to determine the path ahead.
But even though the US may raise policy rates again and even though the UK has yet to reach even ZIRP, let alone NIRP, both economies have benefitted from the global trend this year - which has been a shift down in interest rate expectations. Even where rates have not been cut, financial markets no longer expect central banks to hike as soon or as aggressively as they previously thought. Thus borrowing rates have become cheaper the further ahead one looks.
Also part of this is that some investors are genuinely concerned about what lies ahead, particularly fearful as to whether a repeat of the 2008 crisis is possible. The reason for this is a fear that very low interest rates have encouraged bad behaviour. In particular, financial markets are no longer pricing properly for risk and are thus vulnerable to any shocks.
This is an understandable concern but the performance of financial markets - in the UK and globally - after the UK referendum result suggests that the system may be more resilient than many realise. This is because of a host of sensible regulatory measures that have been put in place in recent years.
But the bottom line is many investors appear more focused on a return of their money, rather than a return on it, opting for the security of government bonds across the globe that now yield low or even negative interest rates. Indeed, the two assets often seen as the safest in a low interest rate environment - namely government bonds and housing - may start to look overpriced and risky as a result of a prolonged period of ZIRP or NIRP.
The second big global policy shift is also important. More countries are using fiscal policy - which combines government spending and taxation - proactively. In the UK it is likely to become evident in the wake of the Referendum result. The UK government is able to borrow at its lowest rate ever and is now likely to use this opportunity to invest more in UK infrastructure.
There are many reasons to be positive about the UK. But the biggest danger for the economy is a combination of policy uncertainty combined with a self feeding downturn triggered by unnecessary pessimism that feeds a loss of confidence.
The economy will benefit from this eventual fiscal boost, as it will from sterling's fall, but even so there will still be the need for interest rates to fall further.
Before the Referendum, it looked likely that UK interest rates would stay low for some time and then rise gradually. Now the combination of global developments and the Referendum outcome means rates can go lower and still stay low. The Bank of England is likely to increase its scale of quantitative easing. It will also likely consider other policy measures aimed at encouraging bank lending.
Then the question is how low rates should go? As UK policy rates are already so low at 0.5% they could go down by any amount. Last month the Bank left rates unchanged; my suggestion then was to cut by 0.125% to start the process.
For now, UK policy rates are unlikely to go negative. Negative interest rates means being paid to borrow and being charged for saving. This is easier to justify for firms than for people.
Instead, 0.25% appears more likely now and zero is possible. In Japan, ZIRP led to what was called "furniture banking"; basically it is easier to keep the money under the mattress. In the UK, the key aim would be encouraging people and firms to spend.