Economics

TalkingEconomics: Negative interest rates open a Pandora’s box

Negative interest rate policy (NIRP) is in fashion but we believe the costs outweigh the benefits. Our concern is that the market overreacts to an economic or financial shock and triggers a financial crisis

05/05/2016

Schroders Economics Team

Negative interest rates are now in vogue amongst central banks and are being heralded as the solution to secular stagnation where fiscal policy has been exhausted.

They were first introduced in order to discourage capital inflows and stop currency appreciation but the European Central Bank (ECB) and Bank of Japan (BoJ) are now using them to boost activity and lending.

The idea is that NIRP effectively puts a charge on deposits, encouraging financial institutions to either lend funds or buy assets, therefore increasing aggregate demand in an economy. However, we believe the costs outweigh most of the benefits to economic growth.

Why negative interest rates may be counterproductive

NIRP is not a cost-free policy tool. There are serious consequences from distorting economies in this way, and potentially even greater consequences from a behavioural finance point of view.

  • Firstly, NIRP creates an incentive for households and corporates to withdraw cash and store it elsewhere.
  • Secondly, banks do not find it easy to pass negative rates on to customers. This is especially the case for retail customers where competition is generally fierce and no bank wants to be the first mover for fear of losing customers, who not only have deposits with their banks, but often mortgages. Instead, banks appear to be taking the hit on their profits.

Banking crisis concerns

Our biggest concern is that the market overreacts, and assumes much deeper interest rate cuts into negative territory, if investors start to worry about an adverse economic or financial shock.

This could prompt a loss in confidence in the viability of banks, potentially triggering runs on banks and a financial crisis.

Our advice for central banks is to clearly stipulate the new lower bound on interest rates in order to head off misguided sentiment.

ECB President Mario Draghi can continue to promise to do “whatever it takes”, as long as that does not imply deeply negative interest rates at the expense of the banking system.