OVER the past year, a number of central banks took their interest rates into negative territory. Were they successful with the negative interest rate policy (NIRP)? What is the future of NIRPs?
Before answering the question, what is negative interest rate all about? It is actually the nominal interest rate which is set with a negative value.
The central bank and probably private banks will then charge negative interest.
In other words, depositors will now have to pay money to keep their money with the bank instead of receiving money. For instance, if the rate is set at negative 0.2%, the depositors would have to pay two-tenths of a percent on their deposits instead of receiving money.
By introducing the NIRP, there will be a set of macroeconomic variables that will be highly sensitive to interest rates, particularly credit growth, construction spending and house price.
In countries like Denmark, it witnessed a surge in consumer credits from 2015 to 2016, while Sweden saw a slowdown during the same period. As for the house prices, both the countries registered strong gains, in the case of construction, Denmark witnessed a slowdown while Sweden reported a strong outcome.
From the looks of it, it appears that the factors influencing these markets are more likely coming from cyclical factors as opposed to NIRPs.
A surprising scenario from the NIRP policy is that it had limited effect on the exchange rate for the smaller central banks.
When the central banks introduced the NIRPs, they failed to weaken the currencies of smaller countries like Switzerland. Part of the reason could be due to the “safe haven” status of currencies like the Swiss franc against the euro that may have resulted in the exchange rate being largely invariant to changes in the interest rate spread between the two countries and the franc was to a large degree pegged to the euro.
However, the larger central banks showed a different reading.
They appear to be more successful in achieving their currency targets through interest rate policies (including NIRPs) than small central banks.
The Bank of Japan had greater success in weakening the yen against the US dollar since it moved to unconventional policies, including negative interest rates, after the financial crisis. The same applies to the European Central Bank (ECB).
Meanwhile, the NIRPs resulted in a flight to cash.
Demand for cash grew for some countries as interest rates declined. For example, Switzerland saw its bank note circulation increase after the introduction of NIRP.
In Japan, cash holdings have also risen, but this trend was already in place before negative interest rates were introduced. In Sweden, the trend has been towards lower cash holdings despite declining interest rates – as more efficient, electronic transaction technology outweighed the lower opportunity costs of holding cash.
The NIRP has several setbacks. NIRPs can affect bank’s profitability, even when a flight to cash does not occur.
With the banks unable to pass on the negative rates to depositors, or if they cannot maintain bank lending rates at levels sufficient enough to safeguard a normal rate of profit, their ability to lend could decline. It can reduce banks’ lending and thus weigh on the economic growth while inflating the risk of deflation.
Also banks can get hurt by NIRP especially if their balance sheets are not too strong.
What could happen is that there will be a switching from riskier assets like loans into ‘safer’ assets such as bonds. When this takes place, it can exacerbate the credit crunch and economic downturn.
On the whole, is there a future for NIRPs?
From the looks of it, this policy has at least so far failed to exhibit different effects on the economy from what is expected during periods of conventional policy easing.
That could partly be because the negative rate and the breadth of the policies’ application has been limited so far.
If that is the case, do policymakers need to apply NIRP more robustly should another economic downturn set in, given the current strong uncertainties on the global front coming from European elections, US policies and the direction of the Chinese economy amongst others.
Or should they look for alternative policies?
Much will depend on whether other policy tools will be at the disposal of central banks and are they more effective?
Small economies trying to reduce pressure on their currencies may find negative rates easier to implement than letting their central bank balance sheets expand due to large purchases of foreign bonds.
On the other hand, larger economies – notably the eurozone and Japan – currently seem to be losing confidence in the effectiveness of negative rates in addressing the problems of slow economic growth and low inflation.
Anthony Dass is head of AmBank Research, AmBank Group