Monday, March 21, 2016

Negative Interest Rates: Should the Federal Reserve Implement Them?

Monetary policy has been interesting in the past few years because of some of the unconventional tools that were used since the Great Recession, most notably with quantitative easing. Now another unconventional tool is making its way around the policy world: negative interest rates. The payment on top of a principal loan from a borrower to a lender to borrow money is known as interest. In banking, the interest rate is the percentage of principal that the lender charges the borrower to use the money for a certain period of time. Traditionally speaking, a customer or financial institution puts their money in the bank to get a return on allowing for banks to borrow their money. The economy has gotten so bad that the interest rates that certain central banks are charging are now negative.

Take Japan as an example. At the end of January 2016, the Bank of Japan implemented a -0.1 percent interest rate, which is to say that the BOJ is charging a 0.1 percent fee to store its money with the BOJ. Upon this announcement, the TOPIX Banks Exchange Traded Fund, which is a Japanese exchange-traded fund, dropped about 28 percent for about the past month before it even began started recovering. Japan's central bank is not the only central bank to charge negative interest rates. There is the Eurozone, Switzerland, Sweden, and Denmark whose interest rates have gone sub-zero. The reasons why these European entities are going for negative interest rates: The European Central Bank is trying to prevent deflation, Denmark wants to maintain its peg to the euro, Switzerland wants to disincentivize currency appreciation via mass foreign inflows, and Sweden wants to create inflation. Even if successful, these implications would provide few insights for the United States, which I'll elucidate upon momentarily.

Essentially, central banks are charging institutional depositors [above a certain reserve threshold] instead of paying them. Although it might seem counterintuitive because cash carries an implicit rate of 0 percent, some would still store money at a negative interest rate because money, especially in large sums, can be quite costly and risky to store. A modest fee can be viewed as better than the alternative. There are a couple of purposes to negative interest rates. One is to help meet inflation targets set by the central bank to make sure there is neither hyperinflation nor deflation, and the other is to nudge commercial banks to lend more money to businesses and consumers (instead of racking up large balance sheets with the central bank) in order to generate a wealth effect. Lower interest rates make savings less attractive and borrowing more attractive, which is what these central banks are trying to encourage. Since oil prices have plummeted and global economic growth is very modest, these central banks are not worried about the inflationary pressures that would typically accompany such policy (more on that below).

We see that some other countries are doing it, but there is a question of whether such policy would take place in the United States. Federal Reserve Chairwoman Janet Yellen stated back in February that they're not off the table, but it looks like that after her press conference last week, negative interest rates are not being discussed. In practice, I'm presently not worried that Yellen would actually go the route of negative interest rates because a) the Federal Reserve recently increased interest rates for the first time in about a decade, and b) a lot would need to go wrong in the economy for Yellen to even consider it, let alone actually do it. While the Federal Reserve is not making any moves towards negative interest rates, former Federal Reserve Chairman Ben Bernanke published a policy brief last week as to whether the United States Federal Reserve should use that tool in the event of an economic slowdown.

As Bernanke points out, it's not the first time the United States has dealt with real interest rates that were negative. It's now that we are talking negative nominal interest rates is where the issue lies (here is an explanation between the difference between nominal and real). Although I can see the intuition behind central banks instituting negative interest rates, I can also see the reasoning behind the concerns expressed by the EconomistBloomberg, and the Wharton School of Business, the latter of which is ranked as one of the top business schools in the country. If the commercial bank decides to pass on the cost of the negative interest rate to the customer, customers are more likely to pull their money out of the bank. In a worst-case scenario, that could lead to a bank run, which would be disastrous. This would be quite ironic considering that one of the reasons for such a policy is to encourage freer flow of funds throughout the financial sector. Even if the banks absorb the costs, the loss of profit could lead to downward pressure on bank stocks, which would mess up the global equity markets. Additionally, it would make banks more recalcitrant to lend money in the future. This could also affect foreign exchange markets because the bigger the differential between a domestic negative interest rate and a positive interest rate in another county will only incentivize investment abroad, which would exacerbate the already-anemic economic growth, particularly in Europe and Japan. If investors do seek better rates of return in other countries, it would lead to currency depreciation of the domestic country. As a matter of fact, we have seen the euro depreciate in comparison to the dollar since the European Central Bank set negative interest rates back in mid-2014. Much like with low, but positive interest rates, the World Bank has expressed concerns about the undesirable effects on capital market functioning and the erosion of bank profitability. The Bank for International Settlements (BIS) expressed concern in a policy brief earlier this month by saying that prolonged negative interest rates come with "great uncertainty."

As the BIS report points out, there is greater wanting for more empirical evidence on the matter, which makes sense considering how new of a monetary policy tool this is. Even so, I still have to retain my skepticism. For one, the United States has already tried to lower interest rates, as well as trying to use quantitative easing to boost economic growth, with little success. Not only would negative interest rates be just a larger attempt to encourage borrowing via interest rates, but it would disincentivize savings because although central banks can only control short-term interest rates, they do have an effect on long-term interest rates. Another reason for skepticism is because there has not been a time in the history of monetary policy where a country generated wealth through devaluing its currency. Regardless of whether we are talking about Japan, Europe, or the United States, I think that there are tax and regulatory reforms that could be implemented without resorting to this currency manipulation. Whether we like it or not, negative interest rates are not going away anytime soon. I would like to see what the empirical evidence has to say on the matter, but at the same time, I'm not going to hold my breath for positive results.

9-10-2016 Addendum: The Brookings Institution recently published an article arguing that negative interest rates are not effective.

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