Monetary policy’s last desperate roll of the dice


WHEN what should be a rare measure to be deployed only under extreme, short-term circumstances suddenly becomes a popular policy tool, it might be time to be gravely concerned about the state of the world economy.

The Bank of Japan recently surprised everyone by adopting negative interest rates, following the lead of the European Central Bank and a couple of individual central banks in Europe (Sweden, Switzerland, and Denmark).

Even in the US, where the economy is not nearly as stagnant as it is in Japan or Europe, Fed Chair Janet Yellen, who in her confirmation hearings in November 2013 said rather forcefully that even positive interest rates that are close to zero could distort money markets and compromise financial institutions’ funding, the negative interest rate option is now considered “on the table.”

In theory, negative interest rates are just an extension of the rationale behind simply lowering benchmark rates: The idea is to put more money into the economy by encouraging lending. Negative rates in effect punish banks by charging them for deposits, and because banks are reluctant to do the same to their depositors, negative rates should have the desired effect rather quickly. The increase in money circulating in the economy will, of course, cause inflation, but that can be solved with a relatively modest increase in rates back to positive levels once demand and spending has picked up again.

Of course, real-world experience has made a mockery of economic theory, because negative interest rates have had some unforeseen consequences; even though the impact has been relatively mild so far, the indications are that if allowed to go on long enough, the negative interest rate trend will actually backfire and result in something worse than what it was trying to fix.

Two indications that things are heading in that direction are the increase in negative rates for government securities—about a third of European debt issues now have negative yields—and a perceptible increase in currency devaluations.

Negative bond yields discourage investment, since investment instruments that return less than the original investment sound like a good idea to precisely no one. Because these securities are how governments partly fund their spending, that will tend to decline as well and put further pressure on the economy.

Currency devaluation is happening for a couple of reasons, but in the context of negative (or, as the Fed’s Yellen observed, even near-zero) interest rates, one aim is to try to keep banks from being forced to impose negative interest on their own customers. Devalued currency makes export lending more profitable (which dovetails with the overall goal of boosting economic activity), and that helps to moderate the shrinking difference between lending and deposit rates’ profit margins. Without the currency support, that squeeze makes banks even less inclined to lend, which, of course, is exactly the opposite of what is supposed to happen.

The biggest risk of negative interest rates is that if they persist for too long—and no one really knows how long that is—the banks will eventually be forced to pass them along to their own depositors. It has already happened in fact; Julius Baer started charging large depositors about a year ago. While that hasn’t turned into a trend yet, there is certainly nothing happening in monetary policy now that is decidedly working to prevent that. If negative bank deposit rates become more widespread, things could spiral out of control pretty quickly: Banks that are already reluctant to lend will start seeing their deposits disappear, and with them the ability to lend even if they wanted to; historically, bank runs or otherwise significant declines in deposits have never resulted in increased spending, and there is no reason to believe this time—if or when it comes—would be any different.

Here in the Philippines, of course, none of this is an immediate concern, and the circumstances of our local economy, although it appears to be cooling down a bit, are such that we can still sit back and smugly praise ourselves for having a sound economy for the foreseeable future. But the Philippines is by no means immune to the outside world; the nagging underperformance of exports is one clue, and the hints of stress on remittances—although not too serious now—are probably another. Our relief at being in what is apparently one of the world’s economic safe zones is not unjustified. By the same token, it’s not something with which we should allow ourselves to become too comfortable.


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1 Comment

  1. This is absurd, if I ever get a notice from my bank that interest rates are going negative I’m putting my money into because I’d rather risk volatility than have certainty that I’ll be losing money.