Negative interest rate policy fraught with risks
THE REAL ECONOMY |
Five of the major central banks among the developed economies have adopted negative interest rate policies during the past few years, creating fear that the U.S. Federal Reserve may follow suit. This unorthodox policy shift is fraught with risks and carries with it the seeds of a return to the beggar-thy-neighbor policies that were characteristic of the worst portion of the global Great Depression during the 1930s. Given the slowdown in overall economic activity in the global economy, the policy-sensitive financial sector will likely bear the brunt of the latest experiment in central banking.
Negative interest rate policy is best understood as tax on excess reserves held by large banks at the central bank. The policy goals are quite straightforward and typically involve directly limiting capital inflows through a reduction of the interest paid on holding government and privately issued securities. The result is an indirect depreciation of the domestic currency and an attempt to spur a general increase in the level of overall prices under conditions that approximate disinflation or deflation. The latter involves inducing an incentive for banks to increase lending to derive a higher rate of return in contrast with the tax paid on holding excess reserves.
The logic of driving rates into negative terrain is similar to reducing interest rates when the economy slows, contracts or unemployment rises; that is, the central bank hopes to influence inflation expectations and reduce both the nominal interest rate and the real interest rate (the rate adjusted for inflation). Lower real interest rates then stimulate overall economic activity through the credit channel and trade channel via devaluation of the domestic currency and an improvement in competitiveness for domestic exporters.
The easy breaching of the theoretical zero boundary on interest rates makes it possible that the U.S. Federal Reserve will consider adopting a negative interest rate policy when the current business cycle comes to an end if the central bank doesn’t reach its ambitious target of a 375 basis-point increase in the policy rate during the next three years as implied by its summary of economic projections. While we do not think that there is a majority of decision-makers on the Fed that would support such a move today, one cannot predict the composition of the central bank going forward, and the level of risks that the Federal Reserve Open Market Committee (FOMC) would tolerate with respect to the condition of the real economy and financial sector if there is a large external economic shock to the economy.
If the Fed ever adopts such a policy, the risks to the financial sector and the middle market cannot be overstated. The money market mutual fund industry would likely cease functioning and a negative interest rate policy would wreak havoc with tax planning for the 200,000 middle market firms in the country that are responsible for 40 percent of gross domestic product (GDP) and employ one-third of all workers.
Middle market insight: Under conditions of negative interest rate policy, middle market firms would likely turn to making prepayments on taxes and utilities to avoid the costs of holding cash.
Under a framework of a negative interest rate policy, the benefits are limited but clear. The risks around the policy, however, are asymmetric and fall under four general categories:
Avoidance and hoarding: The imposition of a tax on holdings of excess cash would likely result in large banks moving to store cash despite the cost of insurance, transportation and storage. Should banks be allowed to pass the cost of taxation along to consumers, then households would likely move to holding cash in safety deposit boxes or personal safes. All of the above will distort financial conditions and household spending.
Banking system: If a negative interest rate policy is sustained, a parallel financial system would almost certainly evolve as an option for households seeking to avoid the cost of taxation. This would cause a general deleveraging of the banking system itself. Even if laws are passed to prevent banks from passing on costs to depositors, the deadweight caused by the tax would generally result in losses via declines in the share price of the banks.
Policy alignment: One of the indirect policy goals of negative interest rates is an improvement in the competitiveness of domestic exporters. While the notion of currency wars is a popular talking point in the financial press, policy coordination and the development of currency swap agreements to prevent funding problems have ensured that this is not the case. One problem with the advent of negative interest rate policy is that it opens the door for a return to the beggar thy neighbor competitive currency depreciations during the 1930s.
Asset bubbles: Under conditions where central banks have to risk stoking asset class bubbles to improve employment, the adoption of negative interest rates is a rational and reasonable response from the point of view of policymakers. In Sweden, where negative interest rates were adopted in 2014, home prices have increased and about half of all mortgages are of the variable rate variety. More than 90 percent of those loans will reset within five years. If the Swedish central bank raises rates during that time, it would carry with it the risk of piercing the bubbles that are building in the housing and financial system.
Meanwhile, there are stark differences in the construction, depth and breadth of U.S. capital markets, compared with those in Europe and Japan. Foremost among those differences is the important role money market funds play in the absorption of short-term securities issued by private financial actors. If money market funds aren’t allowed to pass along the costs of this policy to their clients, they may be caught in a situation similar to what occurred during the financial crisis when some funds were forced to break the buck.
Given the size of the Fed’s balance sheet, and the $ 2.5 trillion on reserve, a large quantity of reserves would have to be made exempt. For example, assume that the Fed imposed a tax of 2.6 percent on excess reserves, which is the same as the European Central Bank. That would only hit $625 billion of reserves, leaving $1.87 trillion, or about 75 percent of reserves untouched. Given that only a fraction of the reserves subject to taxation would likely be actually lent to creditworthy customers, the risks around the policy in the United States strongly imply that such a policy could result in monumental distortions to both the economy and financial system.