Do Negative Interest Rates Work?

For most of us, including those trained in finance and the more practical side of economics, negative interest rates are anything but intuitive. The thought that a dollar today could be worth less than a dollar in a year’s time flies in the face of everything that standard textbooks teach.

 

Old Idea

Yet the idea has been floating around the economic literature for well over a century. Silvio Gesell, a German businessman and monetary economist, faced devastating deflation in the 1890s while living in Argentina and noticed people were hoarding cash. He proposed a stamp tax on currency – effectively a negative interest rate – to force people to spend and thereby keep cash circulating in the economy.

During the Depression, leading economists of the day John Maynard Keynes and Irving Fisher debated whether Gesell’s ideas might be a means of reinvigorating monetary policy and stimulating the economy. Keynes saw merit in the idea but Fisher was sceptical.

 

How It Helps the Economy

More recently, some economists have suggested that cutting interest rates into negative territory should have the same economic impact as cutting rates when they are positive. The idea is that if real interest rates are sufficiently low relative to inflation (or deflation), then at some point people will have incentive to spend and borrow and invest and thereby revitalise the economy.

But for negative interest rates to work they have to be passed through to the broader economy. The binding constraint for a negative interest rate policy, as Gesell noted, has always been currency, which has an interest rate of zero. When inflation is high people have little incentive to hold cash, since if they do, goods and services will be more expensive in the future. Likewise, during deflationary periods it pays to hold cash because things get cheaper. To deal with this problem economists have proposed variations on Gesell’s stamp tax, or even considered replacing currency with electronic cash.

It is no secret that countries that have imposed negatives rates have achieved a degree of stability but have not been able to stimulate a resurgence of inflation or return interest rates to normal (or pre-crisis) levels. Is the problem the theory? Or is it more a matter of implementation? Well, the answer is more nuanced.

 

The Recent Experiences

Let’s first consider the experience of the US. When the economy hits a recession the Fed has routinely cut the Fed Funds rate by five points or so, bringing the real Fed Funds rate to below zero, and even on occasion dropping as low as -1.5% for brief periods (see chart below).

Traditionally, this move was always enough to restart the economy. During the current recovery, the real Fed Funds rate hovered between -1% and -2% from 2010 until late 2016 when the Fed’s rate hikes kicked in. During this time inflation remained in the tight range between 1.5% and 2% that it’s been in since the mid-1990s, and GDP has averaged a modest 2.2% growth rate.

In Europe, the real policy rate has been near -2% for the first and last third of the period since the Great Recession. During the middle period inflation picked up modestly and the European Central Bank responded by raising its policy rate – prematurely as it turned out.

What stands out for both the US and Europe is that even though absolute level of policy rates have been highly unusual, the relative level of real rates has been roughly in line with historical experience – although real rates have stayed lower for a lot longer. Further, both inflation and GDP growth have mostly stayed in narrow ranges, albeit at modestly lower levels than policy makers wanted to see.

In short, the great experiment with unconventional monetary policy in the form of low and negative policy rates has been more of a minor variation on a well-known playbook. And arguably it worked after a fashion.

 

Missing Spark

What’s been missing in both the US and Europe has been the more robust jumpstart in economic activity that typically follows a recession. A big contributing factor has been sluggish bank lending (by pre-crisis standards) in both the US and especially in Europe. This almost surely has more to do with tighter regulatory scrutiny and higher capital standards than any adverse reaction to unconventionally low policy rates. Some have criticised the Fed and ECB for not cutting rates more aggressively, but even if they had it is unlikely they could have overcome regulatory inertia.

That leaves one question wide open: what happens come the next significant downturn? The US has always had the ability to cut rates by 5% when required. And the ECB was able to cut its policy rate by 3% in 2008-09. Assuming we remain in a low rate environment, neither central bank will have that option unless they are prepared to go seriously negative.

But they may not need to.

The Inflation Issue

The wildcard could be inflation. If core inflation remains somewhere above 1%, central banks may be able repeat their policies of the past decade and set real policy rates in the conventional -1% to -2% range with only moderate rate cuts. And it might work.

Should inflation fall much below zero, however, they will have little choice but to move more seriously into the negative to achieve modestly negative real rates. They will be testing and perhaps pushing through the unknown zero lower bound where currency might start morphing into paper gold.

That deflation scenario may not be their base case, but still, we can only hope they are preparing for that day. And don’t forget the bank and corporate IT departments who will be facing another Y2K tsunami if their systems can’t handle negative interest rates.

 

Chart 1: US – Real Rates vs. GDP and Inflation

Source: Bloomberg

 

Chart 2: Europe – Real Rates vs GDP and Inflation

Source: Bloomberg

 

 

 

 

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

 

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)