How low can central banks go? Until recently, it was assumed that policy makers had to stop once they had cut nominal interest rates to zero.
But negative interest rates — charging commercial banks for the privilege of holding reserves with the central bank — are being more widely deployed. Countries accounting for almost a quarter of global GDP now have sub-zero interest rates – including the euro zone, Switzerland, and most recently Japan.
Even in the U.S., where 100 basis points (one percentage point) of rate hikes were priced in at the end of 2015, markets now attach a 10-percent chance (four times higher than the start of this year) that the Federal Reserve will impose negative rates over the next 12 months, in response to softer current economic activity indicators.
Those central banks that have gone negative believe it could boost growth and markets in several ways.
First, the policy should encourage commercial banks to make loans to avoid charges on cash in excess of mandatory reserves.
Second, sub-zero rates also have the potential to weaken a nation's currency, making exports more competitive and boosting inflation as imports become more expensive.
Third, by lowering short-dated government bond yields, negative rates should increase the relative appeal of equities, helping that market.
Fourth, negative rates may complement other easing measures (like quantitative easing), and signal central bank resolve to tackle persistently below-target inflation.
That is the theory. But the brief history of negative rates shows things haven't always gone according to plan. So what are the limits of the policy and its possible unintended consequences?
Credit conditions might actually tighten. For negative rates to boost bank lending, commercial banks must become willing to lend more, and/or at lower costs. A sticking point is that negative rates tend to squeeze bank profits — trimming the gap between the rates at which they borrow and offer loans. If profits suffer too much, banks may even scale back lending. Difficulties in imposing negative rates on depositors may mean debt costs rise for other consumers; Swiss and Danish banks have hiked borrowing costs for homeowners since negative rates were introduced.
Equities don't always respond. Negative rates can promote a shift from bonds to stocks. But this effect has not been clear recently. Since banks form a large proportion of equity market capitalization, as in the U.S. and Japan, shrinking bank profitability may drag on stock indices.
Foreign-exchange rates aren't playing ball. Negative rates should lead to currency depreciation. This link, too, appears to have broken recently. The yen has appreciated 5.4 percent against the U.S. dollar since Japan's policy move, with rising risk aversion overriding interest rate differentials.
Central banks may go too far. European Central Bank President Mario Draghi has said there are no limits to the ECB's potential easing. But there is a limit to how negative rates can go. At a certain point, commercial banks could be forced to charge clients to hold deposits, which could lead many to convert savings into physical cash.
Central banks are determined to do what it takes to boost growth and inflation. With interest rates already at zero, more central banks have been resorting to negative interest rates to fulfill their objective. But as policy becomes more unorthodox, investors will need to monitor potential unintended consequences more closely.
Commentary by Christopher Swann, a strategistin the Chief Investment Office at UBS Wealth Management, which oversees the investment strategy for $2 trillion in assets. Follow UBS on Twitter @UBS.
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