Negative interest rates are back in the headlines again. Markets have begun to price-in a chance that both the US Federal Reserve and the Bank of England will be forced to cut rates and break the zero bound in an attempt to support their economies and offset growing disinflationary pressures. But how likely is this and why is it being talked about now?
The policy of taking interest rates into negative territory was most notably adopted by the ECB in the aftermath of the sovereign crisis. Having always been seen as taboo or more of a theoretical exercise, this was one of the many “red lines” that Mario Draghi crossed as part of his “whatever it takes” mantra. The concept was that by offering negative interest rates on deposits, investors would instead take their cash and spend or invest it, thus bolstering economic activity and inflation.
While some others followed, the major central banks chose not to, instead relying on a variety of asset purchase schemes to support their economies. By 2019, it felt that, collectively, Central Bankers had lost faith in the benefits of negative rates and instead talked of “normalising” rates – in the case of the ECB; or exiting negative rates completely – in the case of the Swedish Riksbank. Adamant that their economy would be better off without negative interest rates, the Riksbank hiked rates to zero in December last year, not because their economy needed higher rates, but simply because they viewed the costs of sub-zero rates as outweighing any benefits.
The reason negative rates are being talked about now is clear – the unprecedented economic collapse that we are in the midst of is asking a lot of Central Banks, causing some to wonder whether they are running out of ammunition and that further interest rate cuts may in fact be needed. With the US Fed and Bank of England both at the effective lower bound, any further cuts would require them to cross the zero bound. In the last week both Jerome Powell and Andrew Bailey have had to answer questions on this topic. Of course, “Central Banking 101” teaches you to never rule anything out completely and while they both pushed back on the need to do it now, it was not a “no, never” response. This way, front-end rate expectations will remain anchored as markets cannot completely dismiss the chance of negative rates.
Do I think they will cut rates into negative territory? Both the Fed and the Bank of England still have a lot of flexibility in their QE programmes and the Fed, in particular, has shown itself to be very creative when stimulus is required. Adding to that the lack of clear evidence of the benefits of negative rates, then I think they will choose to explore other avenues if needed.
For those countries who have less flexibility on asset purchases, there may be no alternative. The Reserve Bank of New Zealand (RBNZ) is a recent addition to the QE club, but with only a relatively small bond market available to them, they may exhaust their QE buying and be forced to look elsewhere. In fact, the RBNZ asked its domestic banks to be “operationally ready” to deal with negative rates by year-end. A case of planning for the worst, perhaps?
While others may do so, ultimately I don’t think the US and UK will cut rates into negative territory – but with a slew of mixed messages coming from the Bank of England, my confidence in that view is decreasing. If negative rates are still seen as a “red line”, it appears to be a thin one that may get all the more thinner. In the face of this crisis it seems nothing can be completely discounted.