Monique Frederick, Butterfield
Who could have ever imagined a world where you lend money with the full acknowledgement that you will be repaid less than the amount owed? So, rather than receiving interest on your hard-earned cash, you pay the borrower for the privilege of taking this cash off your hands.
This is now a startling reality – at least for banks – in the eurozone, Switzerland, Denmark, Sweden and Japan. The zero interest rate policy (ZIRP) we have finally become accustomed to is progressively fading into the abyss as we make way for another acronym gaining popularity: NIRP (negative interest rate policy).
Why do it?
The euro currency bloc and four other countries have adopted negative rates, but not all for the same reasons. For Switzerland and Denmark, the impetus to breach the theoretical zero interest rate floor was to counter a steadily appreciating currency. The main objective was to stall the inflow of foreign investment creating upward pressure on the local currency. The European Central Bank implemented this strategy in an attempt to generate inflation – or prevent deflation – in the Eurozone and to stimulate the economy. Like Sweden’s Riksbank, the Bank of Japan joined the NIRP club to fight the growing threat of deflation.
In theory, the over-arching goal of NIRP is to get depositors out of savings and into the stock market and the real economy, which will reflate asset prices, resulting in the re-emergence of highly sought after but clearly absent inflation.
How should this work?
All depository institutions are required to hold reserves with the central bank. By taxing commercial banks on all or some of the excess reserves above the minimum required thresholds, central banks are attempting to incentivize financial institutions to lend.
Negative interest rates should further result in devaluation of the domestic currency, therefore improving exports. They are also meant to shift the yield curve and reduce borrowing costs, therefore stimulating the economy. Yet the effectiveness of this remains to be seen as there is no concrete evidence of banks re-leveraging. Instead, we are faced with continued de-leveraging in Europe. While some of the central banks have managed to weaken their currency momentarily, they are still in a race against deflation, eagerly waiting for the baton to be passed on to their preferred opponent – inflation.
Is the US immune?
Now that the precedent has been set elsewhere, speculation surrounding the Federal Reserve traveling down the same road is growing. The U.S. Congress did not pass up the opportunity to grill Fed Chair Janet Yellen on the possibility of negative interest rates in the United States. Although Yellen asked banks to consider negative interest rates in their stress-testing scenarios, she assured Congress that the inclusion was a matter of prudent risk management rather than a guarantee that negative interest rates were imminent.
Unlike other central banks, the Fed has many obstacles to overcome to take the Fed funds rate south of zero. Obtaining legal powers to do so, in all likelihood, would require a court ruling given the current language in the Federal Reserve Act. The dreaded demise of money market funds has long been cited as the main barrier against negative interest rates, as substantial outflows could severely drain liquidity in the commercial paper and repo market. Macroeconomic research firm Capital Economics also points to the fact that Federal Home Loan Banks and agencies like Fannie Mae and Freddie Mac, which are currently maintaining reserves on a non-interest bearing basis, would be presented with an arbitrage opportunity. They also opined that the ensuing political fallout from charging retail customers on their deposits would essentially make NIRP a non-starter in an election year. Given both the legal and operational hurdles to overcome, the Fed would be highly motivated to exhaust all other methods, including more asset purchases, if U.S. economic conditions worsen.
Does it work?
In many of the instances cited, retail depositors have not yet been directly impacted. Commercial banks are either absorbing the costs or only sharing the burden with corporate clients maintaining significant balances. With banks bearing the brunt of the cost, net interest margins are being squeezed even further. If interest rates were to decline even further into negative territory, there could come a point when banks would pass on the full tax to all their customers, providing increased motivation for them to consider holding cash in a vault or under the mattress. Critics believe this could backfire eventually. Today it is too soon to tell if the negative interest rate experiment in Europe is actually working. Surely this provides even greater impetus for the Fed to stick to its data dependent “wait and see” mantra.
Sources: Bloomberg L.P., Capital Economics
Disclaimer: The views expressed are the opinions of the writer and, while believed reliable, may differ from the views of Butterfield Bank (Cayman) Ltd. The bank accepts no liability for errors or actions taken on the basis of this information.