Much Ado About Negative Rates

Last Thursday, fed-funds rate futures dipped negative—seemingly hinting that some traders anticipate the Fed enacting a negative interest rate policy by mid-2021. Accordingly, chatter—and fear—about the prospect is up. President Trump tweeted his support for it. Yet several Fed members, including Chairman Jerome Powell on Wednesday, have stated they have no plans to cut rates below zero. That seems sensible to us. We find little evidence of negative interest rates stimulating growth anywhere they have been tried, mostly amounting to a mild negative. Here is why.

To be clear, we aren’t talking about market-determined Treasury rates, which can (and have) dipped below zero at times.^[i] We are referring to Fed-set overnight rates—like those that influence rates banks charge one another for overnight funds and/or earn by depositing funds at the Fed itself. Presently, these are barely positive.^[ii] Negative rate proponents argue flipping them below zero would boost growth and inflation by spurring banks to lend. But in countries deploying negative rates in recent years—Sweden, Denmark, Switzerland, Japan and the eurozone—lending didn’t get an apparent turbo-boost. 

Sweden’s Riksbank was the first to implement negative rates in July 2009. This first foray lasted until September 2010, and it may seem to have “worked.” An eight-month deflationary stretch ended in December 2009, after which Swedish inflation gradually accelerated to 3.4% y/y in August 2011.^[iii] But this was part of a global trend of higher inflation as the world emerged from the global financial crisis, so it looks less like a policy success and more like a byproduct of the global recovery. Sweden reinstated negative rates in February 2015 and ended them this February. During this span, the policy looks less “successful”: Inflation was at or above the bank’s 2% y/y target less than a quarter of the time.^[iv]

The ECB adopted negative rates in June 2014. Monthly loan growth has averaged a tepid 2.0% y/y since.^[v] That may look like an improvement when you compare it to the preceding 24 months, when lending averaged -1.4% y/y.^[vi] Yet this is also a span when the eurozone was in a regional recession tied to the sovereign debt crisis. Banks in particular had taken a beating from fear over their exposure to sovereign debt. Finally, monthly data show improvement before the ECB’s negative rate policy began.^[vii] Inflation, meanwhile, has lagged the ECB’s 2% y/y target in 64 of 71 months since negative rate policy began, averaging 0.9%.^[viii] Other countries’ experiences with negative rates were similar. Japan adopted negative rates in January 2016, and inflation hasn’t hit the BoJ’s 2% year-over-year target since. It trailed 1% y/y in 44 of 51 months.^[ix] To us, all this demonstrates negative rate policies’ dubious effectiveness.

Banks have roundly criticized negative rate policies—and with good reason, in our view. They act as a tax on bank reserves, forcing banks to choose between dodging the tax, eating it or passing it on to select depositors. Banks are generally slow to pass these costs on to depositors for fear they will lose customers. But some in Denmark, Switzerland and the eurozone have done so in recent years, seeing little alternative. The ECB exempted a portion of banks’ excess reserves from negative rates last September, but many banks are still charging certain depositors. As for what policymakers consider the obvious solution to avoid the tax—lending more—that presumes incorrectly that banks were holding excess reserves simply to earn the small return. They had other reasons, like keeping big cash buffers as ECB regulatory policy toughened. Lending is also a matter of risk and reward. With long-term interest rates also at historic lows for much of the past five years, the reward for taking the risk of lending to all but the strongest, most stable companies was scant. Eating the tax, in many cases, was the lesser of two evils.

Finally, even if you buy the logic that negative rates boost lending, they seem especially ill-suited to the current downturn. As Fed officials have noted, present economic woes don’t stem from high interest rates or insufficient lending—but rather, COVID-related restrictions on commerce. US bank loan growth is actually accelerating—up 11.0% y/y in April compared to 4.2% in February—thanks largely to Fed and Congressional action to funnel credit to cash-strapped businesses.^[x] There is only so much monetary policy can do when confronting outright business closures—and it isn’t all that much, in our view.

That said, if the Fed did start charging banks for their excess reserves, we think it would be a modest headwind only—not a wallop creating another leg down in this bear market. Eurozone GDP grew amid negative rates for years—just slower than otherwise, in our view.^[xi] While tepid, loan growth has been positive since May 2015.^[xii] So, we wouldn’t overrate their impact either way. In our view, the hype surrounding the (distant) possibility of negative rates in the US reflects a long-running—and in our view, erroneous—belief in central banks’ outsized influence on the economy. Negative rates seem unlikely to happen—and if they did, it would be a step backwards, but a small one.