Negative Interest Rates, part I: A Real-Time Experiment

by Ryan W. Smith
In March 2016, the Federal Reserve asked big banks to begin looking at the potential impact negative interest rates would have for stress tests. While this practice of paying money to a bank to hold money is very new, it has already been implemented in certain areas of the world, namely Japan and Europe. The concept, however, is still so new that unintended consequences are only now being uncovered.
This is the first of a three-part series exploring Negative Interest Rates and their potential impact.
Central Banks around the world have written many white papers and conducted thought experiments in group discussions for many years about the impact negative interest rates might have on economies around the world. There have been several episodes of negative interest rates, one of the more notable being the early 1970s negative interest rate in Switzerland, but these instances have been exceedingly rare and short-lived.
However, none of these real-world examples thus far were in countries with a sizable impact on the global economy. That all changed in 2014 when the European Central Bank (ECB) instituted a negative rate for banks holding cash in the ECB overnight.
Japan more recently jumped on the negative interest rate bandwagon. The Bank of Japan assumed that a negative interest rate would depreciate the yen, thereby helping to increase demand of foreign goods and assist the country’s stagnant recovery from the 2008 global recession, when they put the policy into effect on January 29. Early results of their real-time experiment have shown the exact opposite: a rally in the yen has run in concert with a reduction in consumer demand. Many pundits and experts have already judged the experiment a failure.
There is a key difference that most in the financial media are not writing about and that many in the industry are not speaking about, at least publicly. The ECB’s decision only impacted deposits controlled by the ECB itself, while Japan’s dealt with all inter-bank deposits, making the entire country’s banking system, essentially, the first real-time test of negative interest rates on an entire economy.
Europe’s experiment with negative interest rates has been less easy to condemn, system-wide. While the ECB’s most recent change on March 10 to a -0.4% rate on overnight bank deposits at the ECB has not been viewed as a mark of success for the program, several country-related central banks on the European continent have been using negative interest rates for over a year with varying success.
Denmark, for example, has used a negative interest to protect the Kroner’s peg to the Euro since the ECB’s initial 2014 decision to go negative. They have, thus far, maintained stability of both the Euro-pegged exchange rate and within the country’s economy, though overall economic growth has been tepid at best. Switzerland and Sweden are working out similar ideas, but returns have been a bit more elastic for those two countries. However, neither the Swedes nor the Swiss release much data showing the impact of their negative interest rate policies. Most analysts however, feel that the negative rates in those countries have been beneficial, just not as positive as their respective governments had hoped.
The biggest worry regarding negative interest rates has been, in theory, that they can restrict the profitability of banks or lead them to take additional risk while looking for profit. This concern is beginning to be borne out in the numbers. As of February 2016, over $7 trillion in government bonds worldwide had a yield below zero.
Investors buying those bonds will not get their investments back in full, even if holding it to maturity. Likewise, shares in large European banks like Deutsche Bank and Credit Suisse are trading near all-time lows due to declining profitability. Deutsche Bank, for example, released second-quarter 2016 earnings data showing that net income for the quarter was down 98% versus the same quarter in 2015, forcing the company to continue a massive company-wide overhaul.
Thus far, even in Japan and Europe, most banks have not wanted to pass on these negative rates to consumers. However, in both regions, some banks are now charging large depositors for the privilege of having money in their vaults.
What is worrisome in the U.S. is that, in addition to the Federal Reserve adding negative interest rates to bank stress test variables, some U.S. banks have already instituted the practice of negative interest rates for accounts over $1 million. This means that one way or another, negative interest rates will affect the U.S. eventually.
What remains to be seen is the depth, breadth and proximity of their impact.