Negative interest rates: The world turned upside down – 11 March 2016
Latest ECB move highlights negative interest debate.
- Negative interest rates – where lenders pay interest to borrowers – got little attention until recently as they were confined to a few Euro-zone neighbours trying to keep down their currencies and lift inflation back to target. Below target inflation has now resulted in negative policy deposit rates in the Euro-zone and Japan. The ECB is now charging commercial banks 0.4% to deposit their money with it but is willing to pay 0.4% interest to commercial banks who lift lending to household and non-financial business customers. The US and Canadian central banks are also exploring the concept but UK central bankers are less keen, saying it can resemble a “beggar thy neighbour” policy of competitive currency depreciation.
- With interest rates so low in many parts of the world, there is concern that other central banks might one day need to use negative rates in the event of another economic downturn. Australia and New Zealand’s policy rates of 2% and 2¼% respectively are at the high end of the spectrum among OECD economies but very low by historical standards and by the yardstick of rate cuts implemented in previous downturns. Alongside uncertainty over just how many countries might one day face negative rates (it could be a lot if there was a global recession) is the difficulty of knowing just how far rates can be driven into negative territory before banks and retail customers opt to use cash instead. Negative rates take economic policy into unexplored territory and there is a lot of uncertainty over how firms and people will react.
- There is also uncertainty over how far negative rates hit banking and insurance profits or, indeed, whether they will work to lift demand and inflation. Negative central bank policy rates have flowed into money market and sovereign bond rates as well as pulling down retail lending rates but negative retail deposit rates remain rare. The outcome has been a squeeze on bank interest margins that has produced concern for the future viability of the classic bank model of operation. These concerns look exaggerated as some bank business models are hit harder than others, banks found other ways to boost revenue and protect margins and central banks have a lot of discretion over how much pressure they put on commercial bank earnings.
- Negative rates should slightly boost activity in countries applying them, mainly through exchange rate depreciation. Reforms to central bank operations are also possible that could allow cuts into deeper negative territory, producing greater economic impacts.
For further details, please see the attached document.