Four Questions on Negative Rates

1. Is there a limit to this policy?

The answer is yes. If negative interest rate policy is pushed to the limit, the policy rates can decouple from the consumer rates. In reaction to NIRP, banks have responded by hiking the consumer rates or leaving them unchanged, therefore reducing the effectiveness of the transmission mechanism.

From a recent Morgan Stanley Research report,

In particular, banks hiked longer mortgage rates in Switzerland after the rate was cut to -75bp (see Exhibit 4), and in Sweden the spread between 3m Libor and a 3m mortgage rate has reached close to all-time wide levels (see Exhibit 5). In the latter case, the front end of the money market curve is down 130bp since mid-2014, while mortgage rates are down only 70bp, i.e. roughly a 50% pass-through.

Instead of thinking in terms of the usual transmission mechanism, perhaps we have to start thinking of scenarios where the previously accepted mechanism may be broken. Having said that, rather than a premature dismissal, it could be the case that for some countries, an even greater magnitude is required for the policy to work. Hence, the efficacy of NIRP depends on the country itself, and its monetary system.

The discussion of negative rates should also be accompanied by questions about the time period, there should be varying short-term/long-term responses. (The actual mechanics of the effects on banks and negative yielding bonds are widely discussed, so I won’t be touching on them here.)

Consequently, how long should the policy be run if the desired response to the policy is insignificant? At what point do we say, this policy is not working, let’s call it off? Understanding the possible asymmetric effects to negative rates is key to determining a policy’s effectiveness. Or in clearer terms, policies often work well when the economic environment looks up, but may be ineffective when the economy is down. A pre-determined laundry list of factors to monitor and guide the decision may be instructive, rather than a hodgepodge of excuses made up a week before central banks meetings.

2. What of the banknotes?

If rates went even deeper into the negative territory, banknotes in circulation become even more important. Central banks might have an easier time preventing cash hoarding if there is less cash in circulation.

Perhaps reducing banknotes in circulation can kill two birds with one stone. As Larry Summers suggested in the FT (based on Peter Sands’ work), the €500 note and $100 bill are the preferred note for criminals and therefore, should be taken out of circulation. In fact, the €500 is almost six times as valuable as the $100. My only concern is that the banknotes may end up having a greater value than its nominal (printed) one, or that criminals may revert to using Tide detergent as the holder of value.

Edward Chancellor writes in “Just Negative”,

If currency notes were taxed, wrote Keynes, “a long series of substitutes would step into their shoes … foreign money, jewelry and precious metals generally.”

It is a strange time we live in, considering that other policy instruments under discussion include helicopter money and cashless society, the latter to avoid deposit substitution, or Gesell money. Here is Frances Coppola on the impact of negative rates in an economy.

3. What is it good for: to stimulate or to stabilise?

From Bloomberg,

“We have learned that negative interest rates is a tool that works to weaken one’s currency but it doesn’t work to stimulate lending,” Helge Pedersen, chief economist at Nordea in Copenhagen, said by phone. “In Denmark, the negative interest rates have worked because the goal was to defend the currency policy.”

The basic premise is that the policy makes saving so unattractive that people are incentivised to invest or consume. The reality though, is that a currency war is being carried out via competitive devaluation, otherwise known as, ‘Beggar-Thy-Neighbour’ policy. Another oft-quoted phrase is, “our currency, your problem”.

Raghuram Rajan warns of its danger, writing, “Above all, we need to avoid beggar-thy-neighbour policies, such as unconventional monetary policy or sustained exchange-rate intervention, that primarily induce capital outflows and competitive currency devaluations”. Claiming it is all for stimulating the economy via lower lending costs does not carry full credibility when the cannons of currency war have already been shot across the bow.

Regardless of the intention, be it to stimulate the economy or stabilise the currency, Kocherlakota writes that the FOMC should be careful on how they communicate the aims of negative rates if they were to implement the policy,

How then should the FOMC communicate about negative rates?   The messaging from Committee leaders should be relentlessly positive.  It is reasonable to highlight that Federal Reserve staff are studying whether negative rates would in fact stimulate aggregate demand in the US, given the ability of banks and others to substitute into cash.  (After all, most of us thought until about two years ago that going negative would have essentially no effect on aggregate demand given those substitution possibilities.)   But FOMC leaders should be clear that, as long as negative rates do have a stimulative effect, the Federal Reserve is more than willing to use them as a monetary policy tool.

This of course, assumes that everyone does not have access to the Economist, Bloomberg, Financial Times, WSJ, Business Insider and a myriad of blogs that discuss the pros and cons of negative rates. Although I am usually the one who is emphasising clear communications from policy makers, in this case, opinions have already formed. Kocherlakota is overestimating the FOMC – it does not have the monopolistic sway on how agents will view negative rates policy.

4. What can be done to hedge deflation?

We could search for low risk stable businesses with long-dated cash flows, or buy gold and TIPS. A polymer of products, really. Merrill Lynch in a report out today contends that NIRP is ineffective – it has not curbed currency strength, raised inflation expectations, nor boosted the equity markets. If the effectiveness continues to decline, according to the report, then hedging tail risks becomes increasingly attractive.

What is clear to me though, is that the onus shouldn’t be on the market participants to hedge against all forms of policy consequences, intended or otherwise, but for policymakers to form a consensus on a global solution. If we have learnt anything at all from the oil producers, it should be that coordination matters. Borderless finance also means that contagion is a significant threat, a systemic risk underlying the functioning of international markets as a whole.

In their paper, “Is there macroprudential policy without international cooperation?”, Cecchetti and Tucker ask these three questions:

• Does global finance require a common prudential standard?
• Does global finance require international cooperation in overseeing the system’s safety and soundness?
• Does global finance require notification, cooperation and coordination of dynamic regulatory-policy adjustments?

And concluding with,

Our answer to the first question is that global finance does require a common prudential standard, defined as a level of required resilience, applied appropriately to all parts of the financial system. Without adoption of a common resilience standard, the international financial system will fragment and balkanize. In addressing the second question, we explain why shared, collective analysis is necessary to identify and mitigate stability-threatening shortfalls against that standard for resilience. This will be possible only with increased public and private transparency.

Finally, we examine the daunting, but essential, task of implementing a dynamic prudential framework that maintains the system’s resilience even as its structure and risk-taking behaviours change. The policy implications of our analysis focus on the need for global agreement, implementation monitoring, information sharing and even, sometimes given damaging spillovers, collective regulatory responses to emerging threats. Institutions will need to be adapted to make all this feasible.

These researchers are way too optimistic in what central banks can cooperate on, but the idea itself is valid, and a happy medium can reasonably be achieved. If successful, it would be an improvement to the current situation.

Mohamed El-Erian suggests in his latest interview with Barry Ritholtz, that it may be the IMF’s role to do so. To be sure, I think it is Janet Yellen that has to credibly step up as the rep for the leading economies. Bureaucracy could take too long, so perhaps an informal gentlebankers’ agreement between the central bankers might be all that it takes to coordinate policies across the economies.