Negative interest rates' positive side

The European Central Bank just cut its deposit rate, again, on Thursday, to minus-0.4 percent and the market cheered. Five central banks are now in the negative rate club including the ECB, Bank of Japan, Denmark's National bank, the Swiss National Bank and Sweden's Riksbank.

And although negative rates had been generally applauded by investors, the BoJ's move earlier this year appeared to intensify the "risk-off" tone present in markets since the start of the year. Indeed, not only did global equity markets fall further in the days after the BoJ's announcement, but the Japanese yen unexpectedly strengthened as investors fled into traditional safe-havens.

Interest rates
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Markets have three main concerns with negative interest rates:

First, negative interest rates may directly harm the banking sector. Commercial banks make money by charging a higher rate of interest on loans than they pay on deposits – that is, they have a positive net interest margin. But if the rate charged on loans is being squeezed ever lower by falling policy interest rates, and commercial banks are unwilling or unable to set the rate paid on deposits below zero for fear that depositors will withdraw money and hold it as cash, banks' net interest margin is compressed tighter and tighter;

• Second, negative interest rates may represent another escalation of a futile currency war. A weaker exchange rate, which boosts import prices and therefore inflation, certainly appears to be a key channel through which monetary policy easing is acting. But currency devaluation is a zero-sum game: the global economy cannot engineer a currency devaluation against itself. Taken to the extreme, competitive currency devaluations may give way to protectionist trade policies, which would be negative for global growth;

• Third, negative interest rates may be symptomatic of central banks reaching the limits of what monetary policy can do. Markets appear to be increasingly concerned that central banks are out of ammo, and are fretting about how policy makers would tackle another downturn.

However, we find a number of reasons to take a more upbeat view of the eventual impact of negative interest rates:

• First, central banks can take steps to alleviate the impact of negative rates on the banking sector. For example, the BoJ's negative interest rate policy applies to only about 10 percent of commercial bank reserves at the central bank, with the majority of reserves attracting a zero or marginally positive interest rate. This "tiered" system is designed to limit the impact of negative interest rates on banks' bottom line. The ECB, widely expected to ease its monetary policy stance further in March, may be thinking of adopting a similar approach;

• Second, to the extent that negative interest rates stimulate the economy, this is a positive for the banking sector. If markets believe that negative interest rates improve long-term growth prospects, this should raise expectations of higher interest rates in the future and result in a steeper yield curve, which is positive for banks' net interest margin. What's more, in a stronger economy banks should be able to find more worthwhile investment opportunities to lend against, and borrowers are more likely to be able to repay those loans;

• Third, empirically, negative interest rates have not crippled the banking sectors in Denmark, Switzerland or Sweden. In fact, bank lending to the private sector is growing more rapidly in Switzerland and Sweden than in the Eurozone, even though the key policy rates of their central banks are a lot lower than the key policy rate of the ECB;

• Fourth, while central banks may be overly reliant on currency depreciation, negative interest rates should work through other channels as well. Negative rates should lower the cost of loans and therefore support loan demand, lower the cost of capital and therefore encourage investment, and lower the discount rate on asset prices and therefore boost valuations;

• Fifth, while monetary policy makers are rummaging ever deeper into their toolkits, they are not out of options. Central banks could make explicit that quantitative easing (QE) will not be unwound, overcoming the "Ricardian equivalence" that means households don't spend all of the asset-price windfall from QE because they know it will eventually be reversed. Or they could expand the scope of QE purchases to include corporate bonds or equities. More radically, central banks could give newly printed money directly to households; they could raise the inflation target to boost inflation expectations; or they could abolish physical cash to remove any lower bound on interest rates.

None of this is to say that negative interest rates are a panacea for what ails the global economy. Monetary policy makers almost certainly need a helping hand in the form of expansionary fiscal policy. However, with most advanced economies firmly in deficit-reduction mode, that may be a forlorn hope.

Commentary by Paul Diggle, is an economist for multi-asset strategy at Aberdeen Asset Management based in Edinburgh. Follow him on Twitter @pauldiggle.

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