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
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.
This communication is marketing material. The views and opinions contained herein are those of the named author(s) on this page, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.
This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Ltd (Schroders) does not warrant its completeness or accuracy.
The data has been sourced by Schroders and should be independently verified before further publication or use. No responsibility can be accepted for error of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions.
Past Performance is not a guide to future performance. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. Exchange rate changes may cause the value of any overseas investments to rise or fall.
Any sectors, securities, regions or countries shown above are for illustrative purposes only and are not to be considered a recommendation to buy or sell.
The forecasts included should not be relied upon, are not guaranteed and are provided only as at the date of issue. Our forecasts are based on our own assumptions which may change. Forecasts and assumptions may be affected by external economic or other factors.
Issued by Schroder Unit Trusts Limited, 31 Gresham Street, London, EC2V 7QA. Registered Number 4191730 England. Authorised and regulated by the Financial Conduct Authority.