Six central banks try to spur growth by introducing negative rates despite potential hazards from the unprecedented policy.
Central bankers in Europe and Japan are embarking on the monetary policy equivalent of the first-ever dive by a submarine. While pushing interest rates below zero for the first time, they are unsure whether their plunge into uncharted depths will bring progress or adversity.
The Bank of Japan, European Central Bank (ECB) and four of Europe’s other central banks are charging a fee, rather than paying interest, on money held in their reserves. They want banks to shift money away from central banks and into longer-term assets, thereby reducing rates on a broad range of securities including mortgage bonds and corporate debt. In theory, the move could spur borrowing and stimulate economic growth.
But there is a risk of backfire. If rates are cut too far, businesses and citizens may hoard physical cash to avoid losses from negative interest rates, disrupting the banking system and hobbling growth. Especially at risk are banks, insurers and other companies whose profits shrink when long-term interest rates fall more than short-term rates. Lower profits could prompt banks to curtail lending.
The unclear impact from negative interest rates underscores the importance for investors of holding adequate liquidity—including cash—to meet day-to-day operating expenses, buffer against market volatility and have ready capital for any future investment opportunities. Over time, subzero rates will probably boost demand for U.K gilts, U.S. Treasuries and other bonds with positive yields that are issued by governments with comparatively steady inflation and economic growth.
So far, negative rates do not show clear signs of spurring growth or speeding inflation. The International Monetary Fund (IMF)forecast in April that the eurozone and Japan will grow this year by 1.5% and 0.5%, respectively, or 0.2 percentage points and 0.5 percentage points less than its forecasts in January.
The ECB’s introduction of a negative rate in June 2014 has had no obvious impact on banks’ excess reserve accumulation. Nevertheless, the IMF supports such a policy “given the significant risks we see to the outlook for growth and inflation,” José Viñals, director of the IMF’s monetary and capital markets department, said in a blog in April. While saying the policy has provided some stimulus, Viñals conceded that rates too low may trigger cash hoarding, with the possible “tipping point” ranging from -0.75% to -2%.
Even without an outbreak of hoarding, negative rates may hurt retirees and other savers who will need to set aside more money to generate the same amount of income. Indeed, a slump in retail sales in Europe suggests that negative rates are crimping spending. Moreover, investors reaching for yield may take on more risk with less-liquid assets, fueling the emergence of asset price bubbles. For example, negative rates could prompt excessive real estate investment by pushing mortgage rates to record lows.
Negative interest rates may persist for some time as policymakers try to cure severe economic ills in Europe and Japan. The U.K. vote to exit the European Union may slow regional economic growth and intensify pressure for additional monetary easing. Bank of England Governor Mark Carney indicated after the June 23 referendum that fiscal as well as central bank stimulus is needed. In response, investors will probably turn to income-producing assets, like real estate and high-yield debt, along with high-quality U.K. and U.S. bonds. They should exercise caution when reaching for yield—valuations of some high-dividend, low-growth stocks already look excessive in our view.
We cannot predict with certainty the ultimate impact of negative rates on the economy or financial markets. But identifying assets with an attractive balance of downside risk and upside potential should yield good long-term results, regardless of how long central bankers hold rates underwater.
This article was updated on July 14, 2016 to reflect the U.K. vote to exit the European Union.
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